Author: Brian Bertsch

Proposed capital rule changes implementing the Basel III accord will increase the volatility of regulatory capital ratios for U.S. banks, especially during periods of market stress, according to Fitch Ratings. Fitch believes U.S. banks will have to hold additional capital to manage volatility associated with unrealized gains and losses from their available for sale (AFS) portfolio.

In June 2012, U.S. regulators issued a notice for proposed rulemaking (NPR) that would deduct unrealized losses and add unrealized gains to common equity tier 1 capital but would not include unrealized gains and losses on AFS cash flow hedges. Currently, unrealized gains and losses are reported in accumulated other comprehensive income and are not included in regulatory capital calculations.

Fitch views illiquid markets as a primary driver of outsized unrealized losses in AFS portfolios. During 4Q'08, an aggregate amount of $54 billion dollars of unrealized losses existed among the 80 banks in this sample. If such rules had been in place during the 2008 financial crisis, for example, Fitch estimates that over 11% of banks with assets over $10 billion would have experienced a reduction in their T1C capital ratio of 100 basis points or more.

Fitch believes credit products such as non-agency mortgage-backed securities and asset-backed securities have introduced the most potential volatility to bank capital levels, given their potential to exhibit material and prolonged illiquidity during periods of market stress.

The inclusion of unrealized gains/losses in regulatory capital is, in Fitch's view, a pro-cyclical capital policy. This could exacerbate capital needs during market disruptions, since meaningful losses can occur during periods of market stress. Therefore, the NPR is most punitive during times when banks have the least access to capital. As such, the NPR is not consistent with recent regulatory initiatives to reduce pro-cyclical capital policies.

The full report 'Proposed U.S. Bank Capital Rules' is available at www.fitchratings.com.