Bank Capital Reforms: Initial Effects of Basel III on Capital, Credit, and International Competitiveness
Published: 2014-11-20T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The 2007-2009 financial crisis revealed that many U.S. and international banks lacked capital of sufficient quality and quantity to absorb substantial losses. In 2010, the Basel Committee (the global standard-setter for prudential bank regulation) issued the Basel III framework—comprehensive reforms to strengthen global capital and liquidity standards with the goal of promoting a more resilient banking sector. In 2013, federal banking regulators adopted regulations to implement the Basel III-based capital standards in the United States, which generally apply to U.S. bank holding companies and banks and are being phased in through 2019. Some market participants have raised questions about the potential negative impact of the regulations on U.S. banks, including on their lending and competitiveness.
This report examines how (1) the U.S. Basel III regulations may affect U.S. banks, including smaller ones, and (2) implementation of Basel III by different countries and other jurisdictions may affect U.S. banking organizations' international competitiveness. To address the objectives, GAO analyzed data from financial filings; conducted legal and economic analysis; reviewed empirical studies, federal regulations, and agency documents; and interviewed regulators, U.S. and foreign banks, and industry associations.
GAO makes no recommendations in this report. GAO provided a draft of this report to the banking regulators for their review and comment and received technical comments, which were incorporated as appropriate.
section_title: What GAO Found
paragraphs: Although the U.S. Basel III capital requirements may increase compliance costs, they likely will have a modest impact on lending activity as most banks may not need to raise additional capital to meet the minimum requirements. GAO's analyses of financial data for the first quarter of 2014 indicate the vast majority of bank holding companies and banks currently meet the new minimum capital ratios and capital conservation buffer (an additional capital requirement) at the fully phased-in levels required by 2019. GAO estimated that less than 10 percent of the bank holding companies collectively would need to raise less than $5 billion in total additional capital to cover the capital shortfall. Banks with a shortfall tended to be small, with less than $1 billion in assets. The empirical research GAO reviewed suggests that higher regulatory capital requirements will have a modest effect on the cost and availability of credit. Similarly, GAO's economic analysis indicates that raising the additional capital would lead to a modest decline in lending and a modest increase in loan rates. According to officials from the eight community banks GAO interviewed, they do not anticipate any difficulties meeting the capital requirements but expect to incur additional compliance costs. Officials from the 10 global systemically important banks that GAO interviewed said they have been incurring significant costs to comply with the new requirements, but three said that U.S. minimum capital ratios for Basel III tend not to be the binding capital constraint. Most of these bank officials said they expect the requirements to improve the resilience of the banking system.
Jurisdictional differences in the implementation of the Basel III capital standards have arisen, but their competitive effect on internationally active banks is unclear. Basel III serves, in part, to limit competitive disparities due to differences in capital standards, but there are limitations to full harmonization. For example, the Basel capital standards have no legal force; rather, members of the Basel Committee on Banking Supervision (Basel Committee) developed and agreed to the standards, with the expectation that each member will implement them. Thus, jurisdictions may adopt requirements more or less stringent than the minimum standards. Almost all Basel Committee members report having adopted rules to implement the Basel III capital requirements. To help promote a level regulatory playing field, the Basel Committee began conducting reviews in 2012 to assess whether each member's implementation meets the Basel III minimum standards and whether implementation produced consistent outcomes across jurisdictions. These reviews found the rules of the seven members it assessed to date to be generally compliant. However, the Basel Committee's other reviews identified some inconsistencies in how banks across different jurisdictions calculated their risk-weighted assets. As was the case with Basel II implementation, some banks and others are concerned about jurisdictional differences in the implementation of Basel III and their effect on competition. For example, some jurisdictions are subjecting certain of their banks to capital or leverage requirements above the Basel III minimums or exempting banks from certain capital requirements. Because Basel III's implementation is ongoing, the extent to which the differences collectively will affect competition among internationally active banks is unclear. In addition, other factors can affect the competitive position of internationally active banks, such as differences in accounting treatment, cost of capital, and tax rules across jurisdictions.

section_title: Letter
paragraphs: The 2007-2009 financial crisis revealed that many banking organizations  lacked capital of sufficient quality and quantity to absorb substantial   Capital reassures an institution’s depositors, creditors, and  losses.counterparties that unanticipated losses or decreased earnings will not  impair the institution’s ability to protect the savings of depositors, repay  creditors, or fulfill their obligations to counterparties. Because of capital’s  role in absorbing losses, promoting confidence, and protecting depositors,  federal banking regulations require banking organizations to maintain  adequate capital, and regulators set minimum capital levels to help  ensure that institutions do so.
In response to the crisis, banking regulators around the world moved to  strengthen requirements for capital adequacy. In the United States, the  Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010  (Dodd-Frank Act) introduced, among other things, new capital  requirements for bank holding companies and savings and loan holding  companies. At the international level, in December 2010 the Basel Committee on Banking Supervision (Basel Committee) issued the Basel  III framework—a comprehensive set of reforms to strengthen global  capital and liquidity standards—with the goal of promoting a more resilient  banking sector. The leaders of the Group of Twenty (presidents and  heads of state) endorsed the Basel III framework. The framework has no  legal force but was issued by the agreement of the Basel Committee  members with the expectation that individual national authorities would  implement the standards.
For the Treasury’s Office of Comptroller of the Currency and the Federal Reserve Board:  Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Capital  Adequacy, Tradition Provisions, Prompt Corrective Action, Standardized Approach for  Risk-weighted Assets, Market Discipline and Disclosure Requirements, Advanced  Approaches Risk-Based Capital Rule, and Market Risk Capital Rule; Final Rule, 78 Fed.  Reg. 62018 (Oct. 11, 2013) and for the Federal Deposit Insurance Corporation:  Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Capital  Adequacy, Tradition Provisions, Prompt Corrective Action, Standardized Approach for  Risk-weighted Assets, Market Discipline and Disclosure Requirements, Advanced  Approaches Risk-Based Capital Rule, and Market Risk Capital Rule; Interim Final Rule,  78 Fed. Reg. 55340 (September 10, 2013). With minor changes, the Federal Deposit  Insurance Corporation rule became a final rule in April 2014. See 79 Fed. Reg. 20754  (April 14, 2014). associations, and others have raised questions about their potential  negative impact on U.S. banks, particularly smaller banks, and the  economy. For example, some maintain that the regulations will reduce  bank profitability, increase the cost or reduce the availability of credit, or  place U.S. banks at a competitive disadvantage relative to foreign banks.  You asked us to review issues related to the impact of the new capital  requirements. This report examines how
U.S. Basel III capital requirements may affect U.S. banking  organizations, including smaller banking organizations, and  implementation of Basel III capital and other standards by different  countries or other jurisdictions may affect the ability of U.S. banking  organizations to compete internationally.
For the first objective, we reviewed final and proposed regulations issued  by the Board of Governors of the Federal Reserve System (Federal  Reserve), Federal Deposit Insurance Corporation (FDIC), and Office of  the Comptroller of the Currency (OCC) to implement the Basel III  framework. We reviewed studies and other analysis on Basel III issued by  regulators, law firms, consultants, and others, and annual reports and  regulatory filings issued by publically traded bank holding companies. We  analyzed data from the Consolidated Financial Statements for Holding  Companies–Form FR Y-9C (Y-9C) and the Consolidated Reports of  Condition and Income (Call Reports) for March 2014 to estimate which  bank holding companies and depository institutions currently would meet  the Basel III minimum capital ratios, how much capital they would need to  raise (capital shortfall) to meet the requirements, and the change in  funding costs for bank holding companies and depository institutions  associated with the amount of capital they would need to meet the  minimum capital requirements. To understand how higher capital  requirements might affect the cost and availability of credit, we reviewed  empirical studies issued in 2011–2014. We also used our estimates of the  capital shortfall to estimate the short- and long-run changes in the cost of  credit associated with bank holding companies and depository institutions  raising capital to address that shortfall. We interviewed federal bank  regulators and six associations representing U.S. or foreign banks (or  both). We also judgmentally selected and interviewed 8 community banks  (based on their total assets and geographic location) and 10 large,  internationally active banks (based on their status as global systemically  important banks (G-SIB) and home country) to obtain their views on the  impact of the U.S. Basel III requirements.
For parts of our methodology involving analysis of computer-processed  data, including the Y-9Cs and the Call Reports, we assessed the  reliability of these data by reviewing relevant documentation and  electronically testing the data for incorrect values and determined they  were sufficiently reliable for the purposes of estimating the numbers of  bank holding companies and depository institutions with capital ratios that  met or exceeded the new Basel III minimum capital ratios, estimating the  capital shortfall for those that did not, and estimating the impact on the  cost and availability of credit of addressing the capital shortfall. For the  second objective, we reviewed relevant proposed and final rules,  examination manuals, and other documentation from FDIC, the Federal  Reserve, and OCC; reports from the Basel Committee, including  jurisdictional and thematic assessments of its Regulatory Consistency  Assessment Program (RCAP); and prior GAO studies. We also reviewed  studies and analysis issued by law firms and consultants on Basel III  implementation differences across jurisdictions and potential competitive  implications and interviewed the same stakeholders identified above  (except for the community banks). For more detailed information about  our scope and methodology, see appendix I.
We conducted this performance audit from December 2013 to November  2014 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
subsections: section_title: Background
subsections: section_title: Federal Banking Regulators
paragraphs: Although depository institutions may have state or federal charters, all  depository institutions (including banks, savings and loans, and thrifts)  that have federal deposit insurance are supervised by a federal banking  regulator. The federal banking regulators—which generally may issue  regulations and take enforcement actions against institutions in their  jurisdiction—are identified in table 1. These regulators issued the final  regulations to implement the Basel III-based capital standards in the  United States.
Holding companies that own or control a bank or thrift are subject to  supervision by the Federal Reserve. The Bank Holding Company Act of  1956 and the Home Owners’ Loan Act of 1933 set forth the regulatory  frameworks for bank holding companies and savings and loan holding  companies, respectively. The Dodd-Frank Act made the Federal  Reserve the regulator of savings and loan holding companies.
section_title: Basel Capital Accord Framework
paragraphs: Basel III is part of the Basel Committee’s continuous effort to enhance the  banking regulatory framework and builds on the previous accords (Basel  I, II, and II.5).
Basel I. Adopted in 1988, the Basel Capital Accord (Basel I) aimed to  measure capital adequacy (that is, whether a bank’s capital is sufficient to  support its activities) and establishes minimum capital standards for  internationally active banks. It consists of three basic elements: a target minimum total risk-based capital ratio (the ratio of regulatory  capital, the numerator, to risk-weighted assets, the denominator) of 8  percent and tier 1 risk-based capital ratio of 4 percent, a definition of capital instruments to constitute the numerator of the  capital-to-risk weighted assets ratio, and a system of risk weights for calculating the denominator of the ratio.
A bank’s risk-based capital ratio is the ratio of its regulatory capital to risk- weighted assets. Regulatory capital is the numerator of the ratio and risk-  weighted assets constitute the denominator. In calculating a total risk- weighted asset figure, a bank’s total value of each asset is multiplied by a  percentage reflecting its risk level and this adjusted amount is added  across all assets. At a high level, the standardized approach to  calculating risk-weighted assets involves multiplying the amount of the  asset or exposure by the standardized risk weight (percent) associated  with that type of asset or exposure. For example, a $1 million mortgage  with a 50 percent risk-weighting would generate a risk-weighted asset of  $500,000. If a bank were trying to hold capital equal to 10 percent of its  risk-weighted asset, then it would need $50,000 of capital to hold against  this mortgage. Bank capital rules prescribe the standardized risk weights  and reflect regulatory judgment about the riskiness of an asset type or  exposure. Holding equity (or the numerator) constant, a higher  standardized risk weight results in a higher risk-weighted asset amount,  which gives rise to a lower risk-based capital ratio. Over time, bank  regulators realized that Basel I was not providing a sufficiently accurate  measure of capital adequacy because of the lack of risk sensitivity in its  credit risk weightings, financial market innovations such as securitization  and credit derivatives, and advancements in banks’ risk measurement  and risk management techniques. The accord was revised and enhanced  multiple times after 1988 because of its shortcomings. For example,  Basel I was amended in 1996 to take explicit account of market risk in  trading accounts.
Basel II. Adopted in June 2004, Basel II aimed to better align minimum  capital standards with enhanced risk measurement and encourage banks   It consists to develop a more disciplined approach to risk management. of three pillars: minimum capital requirements, a supervisory review of an  institution’s internal assessment process and capital adequacy, and use  of disclosures to strengthen market discipline as a complement to  supervisory efforts. Basel II includes a standardized approach (which  does not rely on banks’ internal models) and advanced approaches for  measuring credit and operational risks. The advanced approaches  generally are applied by large internationally active banks. The advanced  approaches for credit risk and operational risk use parameters from a  bank’s internal systems as inputs into a formula that supervisors  developed for calculating risk-based capital ratios. In addition, banks with  significant trading assets (which banks use to hedge risks or speculate on  price changes in markets for themselves or their customers) must  calculate capital for market risk using internal models. The advanced  approaches allow some bank holding companies to reduce capital from  Basel I. Large internationally active U.S. bank holding companies have  been implementing the first phase—known as the parallel run—of the  Basel II advanced approaches. As of February 21, 2014, eight  advanced approaches bank holding companies had exited their parallel  run, and the Federal Reserve and OCC jointly permitted them to use the  advanced approaches to determine their risk-based capital requirements  subject to the Collins Amendment floor. Banking organizations in most  other industrialized countries are subject to the Basel II capital standards.  In 2009, the Basel Committee issued Basel II.5 to enhance the  measurements of risks related to securitization and trading book  exposures.
Basel III. Adopted in 2010 and revised in 2011 and 2013, Basel III aims  to improve the banking sector’s ability to absorb shocks arising from  financial and economic stress, whatever the source; improve risk  management and governance; and strengthen banks’ transparency and  disclosures. The reforms address bank-level, or micro-prudential,  regulation to enhance the resilience of individual banking institutions in  periods of stress and systemwide risks that can build up across the  banking sector and the amplification of these risks over time. Basel III  significantly changes the risk-based capital standards for banks and bank  holding companies and introduces new leverage and liquidity standards.  Liquidity is a measure of the ability and ease with which assets can be  converted to cash.
More specifically, the new standards include a new minimum common equity tier 1 capital requirement of 4.5  percent of risk-weighted assets (the capital needed to be regarded as  a viable concern); a new capital conservation buffer of more than 2.5 percent of common  equity tier 1 capital to provide a cushion to help companies remain  above the 4.5 percent minimum during financial shocks and to avoid  restrictions on distributions and discretionary bonus payments; and more stringent risk-weights on certain types of risky assets,  particularly securitizations and derivatives.
Basel III defines capital more narrowly than the previous accords. The  new common equity tier 1 capital measure is limited mainly to common  equity, because common equity generally is the most loss-absorbing  instrument during a crisis. Basel III also includes a leverage ratio and two  liquidity ratios (see table 2).
section_title: U.S. Implementation of Basel III and Other Banking Reforms
paragraphs: In 2013, federal banking regulators adopted regulations to implement  Basel III’s minimum regulatory capital ratios, capital conservation buffer  ratio, countercyclical capital buffer, and supplementary leverage ratio (as  applicable to advanced approaches banking organizations). These  regulations apply to bank holding companies with assets of $500 million or more and all  non-exempt savings and loan holding companies; national banks and federally chartered savings associations; and  state-chartered banks (both non-member and member banks) and  state savings associations.
Certain savings and loan association holding companies with significant  commercial or insurance underwriting activities or assets currently are  exempt from the requirements of the U.S. Basel III capital regulation.
The U.S. Basel III capital regulation seeks to improve the overall  resilience of the banking system by imposing more stringent regulatory  capital and related requirements on banking organizations. While the  Basel III framework was primarily directed at internationally active banks,  federal banking regulators generally apply the U.S. Basel III capital  regulations to all banking organizations—maintaining that this approach  will lead to a more stable and resilient system for banking organizations of  all sizes and risk profiles.
As shown in table 2, all banking organizations are subject to the  standardized approach and minimum regulatory capital requirements, but  advanced approaches banking organizations are also subject to  additional requirements. Advanced approaches banks are defined as  those with consolidated total assets of $250 billion or more or with  consolidated total on-balance-sheet foreign exposure of $10 billion or  more.  The U.S. Basel III regulations generally provide until 2019 to  phase in certain provisions in the regulatory capital requirements. In  addition to meeting the minimum regulatory capital ratios, banking  organizations must meet the capital conservation buffer to avoid  restrictions on capital distributions and discretionary bonus payments to  executive officers. Advanced approaches banking organizations are  subject to the countercyclical capital buffer, supplementary leverage ratio,  and liquidity coverage ratio. Moreover, under section 171 of the Dodd- Frank Act, the Collins Amendment (discussed below) advanced  approaches banking organizations will be required to calculate their risk- based capital ratios using both the standardized and advanced  approaches methodologies and use the lower of each capital ratio to  determine compliance with minimum capital requirements.
In response to public comments about the potential implementation  burden on small banking organizations, the federal banking regulators  made several revisions to the proposed U.S. Basel III regulations to help  minimize the regulatory burden on such organizations. These revisions  include retaining the existing risk weights for residential mortgages; giving  all standardized approach banking organizations the option to elect to  retain the current treatment of accumulated other comprehensive income  in their regulatory capital; and grandfathering the regulatory capital  treatment of trust preferred securities issued by banking organizations  (less than $15 billion in assets as of 2009) before May 19, 2010.
In addition to the Basel III framework, U.S. banking regulators have  implemented several other major financial reforms and supervisory  practices covering banking organizations. They include the following:
Dodd-Frank stress tests. Under the Dodd-Frank Act, banking  organizations with consolidated assets of more than $10 billion must  conduct and report on an annual company-run stress test. Nonbank  financial companies supervised by the Federal Reserve and bank  holding companies with more than $50 billion in consolidated assets  must also conduct semi-annual stress tests. The act requires that the  banking agencies issue regulations that establish methodologies for  the conduct of the company-run stress-tests that provide for at least  three different sets of economic conditions, establish the form and  content of the report that the companies must submit to the  regulators, and require companies to publish a summary of the results  of the required stress tests. In October 2012, the Federal Reserve,  FDIC, and OCC issued final rules implementing the company-run  stress test requirements. Community banks with less than $10 billion  in total assets are not required or expected to conduct the types of  stress testing specifically articulated in the regulations directed toward  larger organizations. For bank holding companies with $50 billion or  more in assets and nonbank financial companies designated for  supervision by the Federal Reserve, the Federal Reserve must  conduct an annual supervisory stress test to evaluate whether the  company has sufficient capital to absorb losses as a result of adverse  economic conditions. The Federal Reserve must publish a summary  of the supervisory stress test results.
Capital planning. Pursuant to the Federal Reserve’s capital plan rule  and related supervisory process, the Federal Reserve assesses the  internal capital planning process of each bank holding company with  total consolidated assets of $50 billion or more and its ability to  maintain sufficient capital to continue its operations under stressful  conditions. Under the capital plan rule a bank holding company must  submit an annual capital plan or planned capital distribution in which it  demonstrates that it can maintain capital ratios above minimum  regulatory requirements and a tier 1 common equity ratio greater than  5 percent under stressed economic and financial market conditions.  The capital plan must include detailed descriptions of all planned  capital actions: the company’s internal processes for assessing capital  adequacy; the policies governing capital actions such as common  stock issuance, dividends, and share repurchases; and all planned  capital actions over a 9-quarter planning horizon. If the Federal  Reserve objects to its capital plan, a bank holding company may not  make any capital distributions, unless approved in writing by the  Federal Reserve.
Activity restrictions. The final rule implementing Section 619 of the  Dodd-Frank Act, commonly known as the Volcker rule, was adopted  by the Federal Reserve, FDIC, OCC, and the Securities and  Exchange Commission on December 10, 2013. The Volcker final rule  prohibits insured depository institutions and companies affiliated with  insured depository institutions, from engaging in short-term proprietary  trading of certain securities, derivatives, commodity futures, and  options on those instruments for their own accounts. The final rule  also imposes limits on banking entities’ investments in hedge funds or  private equity funds, subject to certain exceptions.
Minimum capital requirements. Section 171 (b) of the Dodd Frank  Act (Collins Amendment) requires federal banking agencies to apply  to, among others, U.S. depository institution holding companies and  systemically significant nonbank financial companies, the minimum  risk-based and leverage capital requirements that apply to insured  depository institutions. The minimum requirements cannot be  quantitatively lower than the capital requirements that were in effect  when the Dodd-Frank Act was enacted.
section_title: U.S. Basel III Capital Requirements May Have a Limited Effect on Capital in the Short Term but Are Expected to Increase Compliance Costs
paragraphs: The vast majority of banks and bank holding companies already would  likely be able to meet the new minimum capital requirements and capital  conservation buffer at the fully phased-in levels required by 2019. We  estimated that as of first quarter 2014 more than 90 percent of bank  holding companies currently meet the new requirements and that those  with insufficient capital would need to raise about $4 billion to 5 billion in  capital to cover the capital shortfall and meet the requirements. Our  analysis also suggests that most of the bank holding companies and  depository institutions that did not hold sufficient capital to meet the Basel  III minimums, plus the capital conservation buffer, are relatively small,  with assets of less than $1 billion. The empirical findings from our  literature review and analysis of the capital shortfall suggest that the  higher capital requirements likely will have a modest effect on the cost  and availability of credit. Some market participants we interviewed (eight  community banks and 10 G-SIBs) generally expected the U.S. capital  requirements to increase compliance costs but have a limited effect on  the cost and availability of credit.
subsections: section_title: Analysis Suggests Most Bank Holding Companies and Depository Institutions Currently Would Meet New Minimum Regulatory Capital Requirements
paragraphs: Our analysis suggests that as of the first quarter of 2014, the majority of  bank holding companies and depository institutions met U.S. Basel III  minimum capital ratios, including the capital conservation buffer, at the  fully phased-in levels required by 2019. Furthermore, the total amount of  capital these institutions would need to meet Basel III ratios—the capital  shortfall—is relatively modest. To estimate the extent to which bank  holding companies and depository institutions already met the fully  phased-in Basel III minimum capital ratios, we analyzed balance sheet  data for bank holding companies and depository institutions for the first  quarter of 2014. We estimated common equity tier 1 capital, tier 1  capital, total capital, and risk-weighted assets using calculations  consistent with the regulations federal banking regulators adopted in  2013, which changed the formulas for calculating these amounts. In  addition, we report the estimates separately for the 16 advanced  approaches bank holding companies (including their bank subsidiaries),  which accounted for nearly 75 percent of the total assets held by top-tier  U.S. bank holding companies but less than 2 percent of the number of all  such holding companies (as of the first quarter of 2014).
subsections: section_title: Basel III Minimum Capital Requirements
paragraphs: A majority of bank holding companies and depository institutions that we  analyzed currently would meet each of the separate Basel III minimum  capital requirements if the regulations took effect immediately without a  phase-in period.  As shown in table 3, our analysis suggests that 953 of  the 1,040 of the bank holding companies (over 92 percent) currently hold  sufficient capital to meet the new minimum common equity tier 1 capital  ratio, plus the capital conservation buffer. Similarly, 6,687 of the 6,794  depository institutions (about 98 percent) currently hold sufficient capital  to meet the new minimum common equity tier 1 capital ratio, plus the  capital conservation buffer. Our analysis also suggests that most of the  bank holding companies and depository institutions that did not hold  sufficient capital to meet the Basel III minimums, plus the capital  conservation buffer, are relatively small, with assets of less than $1  billion.
For a more detailed analysis of the minimum Basel III capital ratios presented  throughout this section, see appendix II.
Estimated capital ratio  greater than or equal to Basel III minimum?  No  Common equity tier 1 capital ratio plus  capital conservation buffer (7.0 percent)
section_title: Regulatory Capital Shortfall
paragraphs: The capital shortfalls for individual bank holding companies and  depository institutions that did not meet the Basel III minimum capital  ratios appeared to be relatively modest in some cases but may be  significant in others. For example, as shown in table 4, our analysis  suggests that most bank holding companies that did not meet the new  minimum common equity tier 1 capital ratio, plus the capital conservation  buffer, would need to raise no more than $0.01 billion ($10 million) in  additional common equity tier 1 capital—about 1.65 percent of assets—  to meet the new requirements. However, at least one of these bank  holding companies may need to raise at least $1.12 billion—about 3.39  percent of its assets. Similarly, most depository institutions that did not  meet the new minimum common equity tier 1 capital ratio, plus the capital  conservation buffer, would need to raise less than $0.01 billion in  additional common equity tier 1 capital, or about 1.52 percent of total  assets, to meet the new requirements. However, some of these  depository institutions would need to raise capital in excess of 2.4 percent  of their assets.
Finally, as shown in table 5, our estimates of the total capital shortfall for  all bank holding companies and depository institutions are relatively  modest. For example, bank holding companies that did not meet the  Basel III minimum common equity tier 1 capital ratio, plus the capital  conservation buffer, would need to raise about $4.73 billion in common  equity tier 1 capital to eliminate the capital shortfall. This amount equals  about 0.03 percent of the combined total assets of all the bank holding  companies we analyzed. Similarly, depository institutions that did not  meet the minimum common tier 1 capital ratio, plus the capital  conservation buffer, would need to raise about $0.76 billion to eliminate  the capital shortfall. This amount equals about 0.01 percent of the  combined total assets of all depository institutions.
Our estimates of the numbers of bank holding companies and depository  institutions with capital ratios exceeding Basel III minimums and the  capital shortfall are subject to limitations. Most importantly, the amounts  of some balance sheet and income statement items used to calculate the  amount of capital or the amount of risk-weighted assets cannot be  observed for bank holding companies or depository institutions not  subject to the advanced approaches rule. We made assumptions about  these unobservable amounts that are similar to assumptions the Federal   However, we cannot assess  Reserve made for a comparable analysis.the extent to which our estimates overstate or understate the numbers of  bank holding companies and depository institutions that already meet  Basel III capital requirements or the capital shortfall. In addition, some  bank holding companies and depository institutions may prefer to  maintain a capital buffer in excess of the required minimum levels to  satisfy investors or other market participants. Thus, our estimates may  understate the number of bank holding companies and depository  institutions that would need to raise capital and also may understate the  amount of capital they would need to raise.
section_title: Funding and Other Costs
paragraphs: In addition, our analysis suggests that raising capital to cover the capital  shortfall would have a modest effect on bank holding company and  depository institution funding costs. Funding costs are determined by the  prices of equity and debt financing sources and the amounts used of  each. Because interest payments on debt are tax-deductible, a more  leveraged capital structure reduces corporate taxes, lowering funding  costs. Thus, an increase in the required amount of equity capital would  increase a bank’s cost of capital. The increased funding cost associated  with a 1 percentage point increase in the capital ratio of a bank holding  company or depository institution is approximately equal to the difference  between the return on equity and the after-tax interest rate on debt, all  else being equal.
For bank holding companies and depository institutions that as of the first  quarter of 2014 did not hold sufficient capital to meet the fully phased-in  U.S. Basel III capital requirements, our estimates of the increase in  funding cost associated with raising capital up to the minimum  requirements are relatively modest. we estimated the amount of common equity tier 1 capital that the median  capital-deficient bank holding company would need to raise to meet the  minimum common equity tier 1 capital requirement, plus capital  conservation buffer, to be about $10 million, or 1.65 percent of its total  assets. As shown in table 6, the increase in funding cost associated with  raising this amount of common equity tier 1 capital is about 0.13  percentage points, or about $13,000 for a bank holding company with $10  billion in assets.raising the median amount of common equity tier 1 capital for a capital- deficient depository institution is about 0.11 percentage points, or about  $11,000 for a depository institution with $10 billion in assets (based on  the amount of such capital the median capital-deficient depository  institution would need to raise to meet the minimum requirements).
Our estimates of the increase in funding costs associated with raising  capital are subject to several limitations. First, as discussed above, our  estimates of the capital shortfall are subject to limitations and may either  overstate or understate the amount of capital that bank holding  companies and depository institutions raise in response to the Basel III  requirements. Because the increase in funding costs is related to the size  of the capital shortfall, our estimates of the increase in funding costs also  may be either overstated or understated. In particular, some bank holding  companies or depository institutions may maintain capital in excess of the  minimum requirements (a capital buffer). The larger the capital buffer, the  more funding costs would increase and the more our estimates would  understate them. Our estimates also reflect the median amounts of  capital required by bank holding companies and depository institutions we  estimated would have insufficient capital to meet Basel III requirements  and may not reflect the specific circumstances of an individual bank  holding company or depository institution that may need to raise capital  and may overstate or understate the change in its funding costs.  Furthermore, our estimates reflect the median return on equity and  interest rate on debt that prevailed in the first quarter of 2014, as well as  our assumption of a corporate income tax rate of 35 percent. However,  equity returns, debt interest rates, and tax rates may change, altering the  relative prices of debt and equity and thus altering the change in funding  costs associated with substituting equity for debt. Finally, our estimates  assume that the return on equity will not change when a bank holding  company or depository institution increases its capital ratio. However,  increasing reliance on equity funding reduces the risks to investors, all  else being equal. If a bank holding company or depository institution  increased its ratio of capital to assets, then the return on its equity could  fall as investors demanded less of a risk premium.
Although the U.S. Basel III capital requirements may have little impact on  the capital level and structure of most banking organizations, their full  impact remains uncertain. The capital regulations will be phased in over  multiple years and Basel III is but one of a multitude of regulatory reforms  affecting banking organizations. The higher regulatory capital ratios may  increase the amount of capital banks hold (if they have to hold more  capital than they otherwise would have held based on their assessment of  economic risk), which could increase their funding costs. The increase in  funding costs may result if holding higher capital meant that bank  investors, were not willing to accept a lower return on equity. In addition,  banking organizations will incur compliance costs, such as for additional  staff training and expenses related to new systems or modification of  existing systems for calculating regulatory capital ratios and for  recordkeeping and reporting. For example, in the interim final rule, FDIC  estimated that each bank with $175 million or less in total assets will incur  $43,000 in direct compliance costs, which it concluded would represent a  significant burden for about 37 percent of these banks.approaches banks, only one included any compliance cost information in  its annual report, indicating it devoted thousands of staff hours to comply  with Basel requirements.
section_title: Empirical Research Indicates U.S. Basel III Capital Requirements Are Expected to Have a Modest Effect on the Cost and Availability of Credit
paragraphs: We discuss below our review of empirical studies and our quantitative  analysis the effects of Basel III requirements on the cost and availability  of credit.
subsections: section_title: Empirical Studies We Reviewed Indicate Higher Regulatory Capital Requirements Negatively Affect the Cost and Availability of Credit
paragraphs: Some banks and others generally maintain that equity is more expensive  than debt; thus, higher capital requirements will raise their funding costs.  If this were the case, banks might charge higher prices for loans,  depending on market competition (which could result in less borrowing);  reduce certain lending; or exit certain lines of business if the return on  capital was insufficient. In contrast, two non-empirical studies maintain  that higher capital costs will not increase bank funding costs, because the  increase in capital will make banks safer and cause investors to accept a  lower return.
We reviewed 11 studies—published from 2011 through 2014—that  empirically examine the effects of higher capital requirements on banks  (or lenders), including on cost of capital and the cost and availability of  credit. To identify relevant empirical studies, we conducted searches of two databases, (ProQuest and EconLit) and identified and selected  economic studies from peer-reviewed journals and working papers from  governmental institutions that were published from 2011 through 2014.  We used search terms for selecting the studies, such as interest rate  spread, credit availability, cost of capital, and partial equilibrium. The  results of the studies generally indicate that higher capital ratios—both  tier 1 capital and common equity tier 1 capital ratios—in the United States  will result in a modest increase in the cost of capital for banks and loan  rates for borrowers and a modest decrease in the quantity of loans for  banks. However, the studies also noted that capital requirements are one  of several policies that can affect the cost and availability of credit. Some  of the studies analyze the effect of capital requirements in other countries,  which helps put the estimated effect of Basel III in the United States into a  broader perspective.
Bank funding cost. Two studies examining the effect of higher capital  requirements on the capital costs of banks generally found that raising  capital requirements will increase the capital costs of banks. One of the  studies estimated that increasing the common equity tier 1 capital ratio by  1.3 percentage point would increase the cost of capital for large banks in  the United States by 0.13 percentage point. The study covered eight  countries, and the estimates ranged from 0.00 percentage points  (Canada) to 0.26 percentage points (Japan). The other study estimated  that a 10 percentage point increase in the tier 1 ratio would increase the  cost of capital in the United States between 0.60 and 0.90 percentage  points. These results generally are consistent with our analysis, in which  we estimated that the increase in funding cost associated with a 1  percentage point increase in the ratio of capital to assets was from about  0.07 to 0.09 percentage points as of the first quarter of 2014 (see app. II).
Cost of borrowing. Nine studies examining the effect of higher capital  requirements on loan rates had results ranging from no effect to an  increase in loan rates. The studies generated estimates of the effect of  higher capital requirements on borrower costs, with some covering  multiple countries in North and South America, Europe, or Asia.  Two  studies covering the United States estimated that a 1 percentage point  increase in capital requirements would increase bank lending rates by a  0.12 percentage point and 0.21 percentage point, respectively. The  other two studies that covered the United States estimated that a 1.3 and  2.0 percentage point increase in capital requirements would increase  bank lending rates by a 0.17 percentage point and 0.51 percentage point,  respectively. In comparison, the studies covering other countries  estimated that a 1 percentage point increase in capital requirements  would increase bank lending rates around 0.04 to 0.25 percentage points  (and a 1.3 percentage point increase would increase bank lending rates  from 0.0 to 0.34 percentage points).
Quantity of loans. Four of the studies examining the effect of higher  regulatory capital requirements on the availability of credit found that  higher requirements would reduce the quantity of loans supplied, but the  estimated effect varied across the studies. As bank lending rates  increase, some of the studies generally expect the demand for loans to  be less, thereby reducing the quantity of loans made by banks. Two of the  studies covered the United States and estimated that a 1.3 percentage  point increase in common equity tier 1 capital or 2.0 percentage point  increase in tier 1 capital ratio—will decrease the quantity of loans by 2.97  percent and 8.71 percent, respectively. In comparison, one of the  studies also covered countries in Asia, Europe, and North America and  estimated that a 1.3 percentage point increase in regulatory capital  requirements will decrease the quantity of loans in these countries, but  the estimates vary across countries—ranging from a 0.16 percent decline  to a 32.61 percent decline.
section_title: Raising the Amount of the Capital Shortfall under U.S. Basel III Regulations Likely Would Have a Modest Effect on the Cost and Availability of Credit
paragraphs: Like the studies we reviewed, our analysis suggests that raising capital to  cover the capital shortfall would have a modest effect on the cost and  availability of credit in both the short and the long run. As discussed  previously, the total amount of capital that bank holding companies and  depository institutions would need to raise to cover the capital shortfall  and meet the new minimum capital ratios would be small relative to total  assets, likely less than 1 percent. In addition, most bank holding  companies and depository institutions do not appear to need to raise  capital to meet minimum requirements. For those that do, the amount of  capital they need to raise appears to be small relative to total assets in  some cases but could be large in others. To assess the short-run impact  on the cost and availability of credit for bank holding companies or  depository institutions raising capital to meet minimum requirements, we  used (1) estimates of changes in loan volumes and loan spreads  associated with changes in capital from our prior work and (2) our  estimates of the capital shortfall described above. To assess the long- run impact, we used an existing loan pricing model.
The short-run impact of meeting the new capital requirements on the cost  and availability of credit likely would be small. In prior work, we estimated  that a 1 percentage point increase in the ratio of capital to assets is  associated with a short-run increase in loan spreads of about 0.16  percentage points and a short-run decline in loan volume growth of about  1.2 percentage points. Our analysis of the capital shortfall suggests that  bank holding companies would need to increase total capital by about  0.03 percent of total assets to meet the new minimum total capital ratio  plus the capital conservation buffer. If bank holding companies raised the  capital to cover the shortfall in a single quarter, these estimates suggest  that covering the capital shortfall would lead to an increase in loan  spreads of less than 0.01 percentage points and a decline in loan volume  growth of less than 1 percentage point.
Our estimates also suggest that the long-run impact of meeting the new  capital requirements on the cost and availability of credit also likely would  be small. To assess the potential impact on loan rates, we used an  existing loan pricing model that captures key determinants of loan rates in  the long run, including funding costs, credit spreads, and administrative  costs. As discussed above, funding costs for bank holding companies and  depository institutions that increase equity capital to meet Basel III  minimum capital ratios could increase. Bank holding companies and  depository institutions can respond to changes in their funding costs in  several ways, including raising loan rates, shifting lending activity to  lower-risk borrowers, and increasing efficiency. If bank holding companies  and depository institutions that have to raise capital covered their  increased funding costs solely by increasing their lending rates, our  estimates of the funding cost changes are indicative of the amounts by  which lending rates at these institutions would increase—generally less  than 0.3 percentage points. However, some factors may cause lending  rates to increase by less than this amount. The extent to which bank  holding companies and depository institutions can raise lending rates is  limited by the amount of competition they face from other lenders— including lenders that already hold sufficient capital—as well as other  factors. Thus, bank holding companies and depository institutions that  need to raise capital may cover their increased funding costs by other  means in addition to, or instead of, raising lending rates. For example,  they could increase lending to lower risk borrowers and reduce lending to  higher risk borrowers in order to reduce credit spreads, or they could  reduce salaries or employ fewer people to lower administrative costs. In  this case, lending rates would increase by less than the amount that  funding costs increase.
Our estimates of the impact of meeting the new capital requirements on  the cost and availability of credit are subject to limitations and should be  interpreted with caution. As discussed, our estimates of capital shortfall  and the increase in funding costs associated with raising capital to  eliminate the shortfall are subject to important limitations that could lead  us to overstate or understate them. Because the change in lending rates  is related to both the capital shortfall and the associated increase in  funding costs, it too may be overstated or understated. For example, if  bank holding companies or depository institutions maintain a capital  buffer in excess of the minimum amount of capital required, then the  increase in lending rates likely will be greater than our estimates of the  increase. In addition, past macroeconomic and credit market conditions  heavily influence the methodology we used to estimate the short-run  response of loan spreads and loan volume growth to changes in the ratio  of capital to assets, so the estimates may not apply to future periods if  macroeconomic and credit market conditions were significantly different.  Furthermore, the model we used to estimate the long-run response of  loan rates to changes in the ratio of capital to assets may not reflect all of  the determinants of loan rates.
section_title: Some Market Participants Generally Expect U.S. Capital Requirements to Increase Compliance Costs but Have a Limited Effect on the Cost and Availability of Credit
paragraphs: Although their views are not indicative of the banking industry as a whole,  bank officials we interviewed generally expected that they would be able  to meet new capital requirements, their compliance costs would increase,  and effects of the requirements on credit would not be large. According to  officials from all eight community banks we interviewed, they did not  anticipate any difficulties in meeting the U.S. Basel III capital  requirements but expect to incur additional compliance costs. Because  we interviewed a relatively small number of community banks, compared  with the overall population of banks with assets of less than $10 billion,  we cannot generalize the responses. All the officials said their banks were  well capitalized in excess of Basel III capital ratio requirements and they  did not anticipate having to raise any additional capital or take additional  actions to meet the heightened capital requirements. At the same time,  the community bank officials generally told us that they have been  incurring additional compliance costs because of the new requirements,  but none could quantify the costs. For example, five officials said that they  will need to update their information technology systems or purchase  software to comply with enhanced reporting and recordkeeping  requirements. Two told us that they consulted (or expect to consult) with  accountants, attorneys, or both to understand the Basel III capital  requirements and the implications for their banks. Additionally, six told us  that their staffs have been devoting more of their time to comply with the  new capital requirements, but none said they have hired or planned to  hire additional staff. Finally, four officials told us that several revisions the  federal banking regulators made to the regulations—particularly those  involving the risk weights for residential mortgages, accumulated other  comprehensive income, and trust preferred securities—helped to  minimize their regulatory burden. Similarly, officials from an industry  association told us that community banks fared well under the capital  regulations, which addressed most of the concerns raised by the  association about the proposed regulations.
Consistent with the findings from our review of the literature and analysis  of the capital shortfall, the officials from some community banks told us  that they generally expected the U.S. Basel III capital requirements to  have a limited effect on the cost and availability of credit. Specifically, four  said they did not expect the new requirements to hamper their ability to  lend to their customers. However, several said that the higher capital  requirements for high-volatility commercial real estate might reduce their  lending in this area. Three officials told us that they expect tighter  underwriting standards to make it more difficult and expensive for  marginal customers to borrow, but five expected loan prices to increase.
Officials from two banks mentioned that competition from other  institutions, such as credit unions, could affect loan pricing.
Officials from the 10 U.S. and foreign G-SIBs (large, internationally active  banks) that we interviewed told us that the U.S. Basel III’s minimum  capital requirements generally tended not to act as binding capital  constraints on them. Instead, three of the banks told us that U.S. G-SIBs  are subject to stress-testing under Comprehensive Capital Analysis and  Review (CCAR) by the Federal Reserve, and the capital requirements  under CCAR typically are higher than the minimum Basel III  requirements. To be able to pay dividends to shareholders, the G-SIBs  must meet the capital requirements set under CCAR. In addition, officials  from four U.S. G-SIBs said that the supplementary leverage ratio would  be more onerous or costly with which to comply than the risk-based  capital requirements.
The officials from all the U.S. G-SIBs we interviewed said that they have  expended significant resources in terms of staff and money to implement  and comply with the U.S. Basel III capital requirements. For example,  they said that they have had to hire additional staff and develop new  technology and infrastructure to comply with the regulations. Three told  us that under the Collins Amendment they have had to calculate a total of  six capital ratios—three using the advanced approaches and three using  the standardized approach—which is significantly burdensome. But none  of the U.S. G-SIBs could provide us with a precise estimate of their  compliance costs, in part because Basel III implementation has been  done in conjunction with other regulatory reforms, such as the Dodd- Frank Act, and in part because staffs from many departments were  involved in implementation. However, several officials told us the costs  have been running into the millions of dollars and included significant staff  hours.
According to officials from the 10 G-SIBs, the Basel III capital  requirements are expected to have a mixed effect on their lending and  lines of business. Four of the G-SIBs generally told us they expected the  high-capital requirements to affect lending—namely by reducing the  availability of credit or increasing costs for borrowers (or both). More  specifically, two G-SIBs said the capital requirements will have some  effect on the mortgage market, but one also noted that other factors may  have a greater effect on the market (because it is a highly competitive  market). Two officials told us that the U.S. Basel III regulations may cause  mortgage servicing assets to move from the banking sector to the non- banking sector. In particular, one said that 25 percent of all U.S.  mortgage servicing rights assets have moved outside of the banking  sector because of the new regulatory capital requirements. In addition,  the G-SIBs said that they generally expected the new leverage and  liquidity requirements, along with the capital requirements, to reduce  certain of their business activities, particularly their derivatives and short- term securities financing transactions.
Officials from a number of the community banks and G-SIBs told us that  they expect the U.S. Basel III capital regulation to improve the resiliency  of the U.S. banking system. Specifically, officials from two community  banks said that they expected the capital regulations to improve the  safety and soundness of the banking system, but three community banks  questioned the appropriateness of the regulations for small banks.  Officials from nine of the G-SIBs said the regulations generally would  make the U.S. banking system safer, because higher capital and liquidity  reduce risks to the banking system. At the same time, some said that the  capital regulation could create other vulnerabilities that made the financial  system less stable—for example, by shifting the risk outside of regulated  banks or by reducing the willingness of banks to hold risky assets during  times of market stress.
section_title: The Basel Committee Is Taking Steps to Identify Basel III Implementation Inconsistencies
paragraphs: Differences in regulatory capital requirements across jurisdictions could  affect competition between internationally active banks. For example,  higher capital costs driven by higher regulatory capital requirements could  result in a competitive disadvantage for banks that compete for similar  customers with banks subject to lower capital requirements. As have the  previous Basel accords, Basel III serves, in part, to limit competitive  advantages or disadvantages due to such differences. For example, one  of the two fundamental objectives of the initial Basel accord was that  standards should be fair and applied with a high degree of consistency to  banks in different countries with a view to diminishing an existing source  of competitive inequality among international banks. As specified in its  charter, the Basel Committee’s activities include monitoring the  implementation of Basel standards in member countries to help ensure  their timely, consistent, and effective implementation and contribute to a  level playing field among internationally active banks. At the same time,  there are limitations to full harmonization. As was the case with the  implementation of Basel II, some market participants or observers have  raised concerns about regulatory differences in the implementation of  Basel III between jurisdictions and their possible competitive effects.
subsections: section_title: Most Member Jurisdictions Have Implemented Basel III Capital Requirements, but Committee Assessments Found Some Inconsistencies
paragraphs: According to the Basel Committee’s October 2014 progress report, 25 of  its 28 members reported having regulations in effect to implement Basel  III’s higher capital requirements (see table 7). However, three Basel  Committee members reported they had not yet implemented all the Basel  III capital requirements, namely the conservation and countercyclical  buffers. In September 2014, U.S. regulators finalized their liquidity  coverage ratio regulation, but it will not take effect until January 2015. In  addition to the risk-based capital standards, the Basel Committee  monitors implementation of the additional loss absorbency requirements  for G-SIBs and domestic systemically important banks, liquidity coverage   Basel Committee members generally reported  ratio, and leverage ratio.that they have not yet adopted regulations to implement these  requirements.
The Basel Committee’s assessments of Basel III implementation found  that the jurisdictions reviewed to date have adopted rules generally  consistent with the Basel III standards but identified some inconsistencies  in regulator-approved bank models across countries. According to the  Basel Committee, public confidence in prudential ratios, resiliency of  banks, and a level regulatory playing field for internationally active banks  cannot be achieved without consistency in the adoption and  implementation of the Basel standards. Recognizing the importance of  Basel III’s implementation, the Basel Committee established its  Regulatory Consistency Assessment Program (RCAP) in 2012.assessments are designed as peer reviews undertaken by technical  experts from member jurisdictions and are done on a jurisdictional and  thematic basis.
subsections: section_title: Jurisdictional RCAP Assessment
paragraphs: The Basel Committee has completed seven jurisdictional assessments  and generally found the jurisdictions compliant; additionally, the  committee reviewed European Union (EU) and U.S. draft regulations but  did not assign an overall compliance grade, because the rules still were in  draft form at the time of the review. Jurisdictional assessments review the  extent to which national Basel III regulations in each member jurisdiction  align with the Basel III minimum requirements. They examine the  consistency and completeness of the adopted standards, including the  prudential significance of any deviations in the standards. According to  the Basel Committee, the assessments help highlight the current and  potential impact of any gaps in the regulatory regime, and help member  jurisdictions undertake reforms needed to strengthen their regulatory  regimes. Each member jurisdiction has agreed to undergo an RCAP  assessment, and the Basel Committee has given priority to jurisdictions in  which G-SIBs are domiciled.the Basel III risk-based capital standards, but will be expanded to cover  the Basel standards relating to liquidity, leverage, and systemically  important banks.
A domestic regulatory framework is considered compliant with Basel III if all minimum  provisions of the relevant Basel standard have been satisfied and no material differences  are identified that would give rise to prudential concerns or provide a competitive  advantage to internationally active banks. A domestic regulatory framework is considered  largely compliant with Basel III if only minor provisions of the relevant Basel standards  have not been satisfied and if differences that have only a limited impact on financial  stability or the international-level playing field have been identified. A domestic regulatory  framework is considered materially non-compliant with Basel III if key provisions of  relevant Basel standards have not been satisfied or if differences that could materially  affect financial stability or the international level playing field have been identified. A  domestic regulatory framework is considered noncompliant with Basel III if the relevant  Basel standards have not been adopted or if differences that could severely affect  financial stability or the international playing field have been identified. minimum standards.certain regulatory capital requirements that are more stringent than the  minimums set in Basel III. According to the Basel Committee, the RCAPs  identified no areas to be consistently above the Basel minimums,  suggesting the Basel capital standards generally are not calibrated too  low in the collective judgment of the implementing authorities.
For example, China and Switzerland adopted  The Basel Committee also conducted jurisdictional RCAP assessments of  proposed Basel III rules for the European Union and the United States,  but did not assign them an overall assessment grade because of the draft  nature of the rules.approaches generally complied with the vast majority of Basel III’s key  components. However, the assessments also found certain components  of the proposals to be materially noncompliant. Specifically, the EU RCAP  noted that the proposed approach fell substantially short of the Basel  framework in the definition of capital and the internal ratings-based  approach for credit risk. The U.S. RCAP noted that the grade was mainly  due to the proposed implementation of an alternative approach to replace  Basel use of external credit ratings. The European Commission  expressed concerns about RCAP’s preliminary findings—including that  the assessment did not take into account that the EU is a single  jurisdiction that applies Basel III to all its banks and investment firms,  which necessitates that national regulators employ a certain level of  proportionality in applying the rules. U.S. agencies noted that the Dodd- Frank Act prohibits the use of credit ratings for setting capital charges for  securitization exposures, resulting in a deviation from the Basel III  standards. They also noted that their evidence suggests that the  deviation’s impact will not be material and therefore believe that their  approach is largely compliant rather than materially non-compliant. The  United States and EU are currently undergoing RCAP assessments  based on their final Basel IIII regulations.
The RCAP assessments found both proposed  In a September 2013 speech, the Basel Committee’s Secretary General  acknowledged the limitations of RCAP assessments, recognizing that the  committee has no enforcement power beyond the power of peer pressure  and public disclosure. However, the Secretary General noted that  RCAPs are a strong demonstration of the Basel Committee’s commitment  to international consistency and, where this cannot be perfectly achieved,  to greater transparency. The Secretary General further noted that if an  individual jurisdiction departed from Basel III standards, the nature and  materiality of that divergence ought to be well understood. If a bank did  not operate under regulations consistent with Basel standards, any  difference should be much more transparent when it reported a “Basel  ratio.” According to the Secretary General, in that way markets can have  something of a policing role, offsetting regulatory differences in their  assessment of banks’ financial ratios.
section_title: Thematic RCAP Assessments
paragraphs: Basel Committee on Banking Supervision, Regulatory Consistency Assessment  Programme (RCAP): Analysis of risk-weighted Assets for Credit Risk in the Banking Book  (Basel, Switzerland: July 2013), Regulatory Consistency Assessment Programme  (RCAP): Second report on risk-weighted assets for market risk in the trading book (Basel,  Switzerland: December 2013); and Regulatory Consistency Assessment Programme  (RCAP): Analysis of Risk-weighted Assets for Market Risk (Basel, Switzerland: January  2013; revised February 2013). The trading book refers to securities that a bank would not  hold to maturity and for which it accounts at current market value. The banking book refers  to securities a bank plans to hold to maturity at their original book value. If the bank  decides to sell the securities, it then moves the securities to the trading book, where they  are given fair market value accounting treatment. Average risk-weighted assets include,  for example, the three wholesale assets classes covered by the hypothetical portfolio  exercise (sovereign, bank, and corporate) that account on average for about 40 percent of  participating banks’ total credit risk-weighted assets. standards can lead to variations in the amount of capital banks have to  hold. In that regard, the objective of the assessments generally has been  to obtain a preliminary estimate of the potential for variation in risk- weighted assets across banks and highlight aspects of the Basel  standards that contribute to this variation.
More specifically, the RCAP examining risk-weighted assets in the  banking book found that most of the variation in calculation of risk- weighted assets could be explained by broad differences in the risk  composition of banks’ assets, reflecting differences in risk preferences as  intended under the Basel III framework. But the RCAP also found  differences in bank and supervisory practices drove a material amount of  the variation. Similarly, the RCAPs examining risk-weighted assets in  the trading book found considerable variation in the calculation of risk- weighted assets for market risk across banks. Supervisory decisions  applied to all banks in a jurisdiction or to individual banks were deemed to  be a sizeable driver of the variation, but the variation also was due to the  choice of models banks used to calculate regulatory capital. According to  the Basel Committee Chairman, national supervisors and banks have  been using the assessments to take action where needed. Moreover, in  February 2014, the Financial Stability Board reported that by the  November 2014 G20 summit, the Basel Committee will prepare a plan to  address excessive variability in risk-weighted asset calculations that can  be implemented to improve consistency and comparability in bank capital  ratios.
section_title: U.S. Basel III Capital Rules Generally Apply to U.S. and Foreign Banking Entities and Help Provide a Level Regulatory Playing Field in the U.S. Market
paragraphs: U.S. Basel III capital regulations generally apply to both U.S. banking  organizations and their foreign banking counterparts operating in the  United States, helping to provide a level regulatory playing field in the  U.S. market. In general, U.S. regulation of foreign banks is guided by the  principle of national treatment and equality of competitive opportunity,  which generally means that foreign banking entities operating in the  United States should be treated no less favorably than similarly situated  U.S. banking organizations and should generally be subject to the same  restrictions and obligations in the United States as those that apply to the  domestic operations of U.S. banking organizations.
Foreign banking organizations (such as foreign parent banks) have  structured their U.S. banking operations in a number of ways. For  example, some conduct U.S. banking activities directly through branches  or agencies, while others own U.S. banks directly. Most foreign banking  organizations operate through branches and agencies, because as  extensions of the foreign banking organizations, they do not have to be  separately capitalized and can conduct a wide range of banking  operations. Federal Reserve officials told us that they expect the U.S.  Intermediate Holding Company provisions discussed below to reduce the  variety of operations of foreign banking organizations in the United  States.
The Federal Reserve, OCC, and FDIC supervise and regulate the U.S.  banking operations of foreign banking entities. The Federal Reserve is  responsible for the overall supervision and regulation of the foreign  banking organizations in the United States. Branches and agencies are  licensed and subject to supervision by OCC or state banking agencies.  Subsidiary banks of foreign banking organizations are chartered by OCC  or state banking agencies, and supervised by OCC, FDIC, or the Federal  Reserve or state banking agencies. Although subsidiaries that are  required to abide by U.S. Basel III capital regulations may be owned or  controlled by the foreign banking organization, they are separate legal  entities.
As shown in figure 1, Basel III capital regulations of FDIC, the Federal  Reserve, and OCC generally apply to U.S. and foreign banking entities,  except for foreign branches and agencies. However, some regulatory  differences could arise—for example, if the subsidiaries of foreign  banking entities that are required to abide by U.S. Basel III capital  regulations are independent or will be required to form a U.S.  intermediate holding company.
Foreign banking organizations. The Federal Reserve requires foreign  banking organizations with U.S. banking operations with total  consolidated assets of $50 billion or more to be subject to the  international Basel III capital requirements as established in their home  country. These banks must certify to the Federal Reserve that they  meet capital adequacy standards on a consolidated basis established by  their home-country supervisor that are consistent with Basel III standards.  If the home-country supervisor has not established capital adequacy  standards consistent with Basel III, the foreign banking organization must  demonstrate to the Federal Reserve that it would meet or exceed capital  adequacy standards on a consolidated basis that are consistent with  Basel III were it subject to that standard.organization fails to satisfy the Basel III requirements, the Federal  Reserve may impose requirements, conditions, or restrictions, including  risk-based or leverage capital requirements, on the activities or business  operations of the U.S. operations of the foreign banking organization.  None of FDIC’s Basel III capital rules are applicable to foreign banking  organizations.
Branches and agencies. Branches and agencies of foreign banking  organizations are not subject to U.S. Basel III capital requirements  because foreign banking organizations may operate through branches  and agencies in the United States on the basis of their home-country  capital standards. According to OCC, because federal branches and  agencies have no segregated capital base and are only part of a foreign  banking organization’s earnings stream, measurement of capital at risk is  not meaningful for them.
U.S. intermediate holding companies. In March 2014, the Federal  Reserve finalized a rule to require larger foreign banking organizations  based overseas and having material U.S. operations to establish a U.S.  intermediate holding company (U.S. IHC) for consolidated supervision of  their U.S. subsidiaries. According to the Federal Reserve, the  requirement facilitates a level playing field between foreign and U.S.  banking organizations operating in the United States, in furtherance of  national treatment and competitive equity. Under the rule, U.S. IHCs  would be subject to Basel III capital requirements substantially similar to  those for U.S. bank holding companies. However, those U.S. IHCs that  are advanced approaches banking organizations may choose to calculate  their risk-weighted assets according to the standardized or advanced   Conversely, U.S. bank holding  approaches risk-based capital rules.companies that meet the asset threshold are automatically treated as  advanced approaches banking organizations and must abide by the risk- based capital rule calculation requirements. FDIC officials told us that the  agency will not regulate U.S. IHCs under FDIC’s Basel III capital rules,  because U.S. IHCs are subject to the Federal Reserve’s Basel III capital  rules.
Subsidiaries. Subsidiaries regulated under U.S. Basel III capital  regulations, regardless of whether they are subsidiaries of foreign  banking organizations or domestic subsidiaries, must abide by  substantially similar rules. including any Federal Reserve-regulated institution such as state member  banks and top-tier bank holding companies—subject to its supervision to  comply with the U.S. Basel III capital regulations. Exceptions include  small bank holding companies and foreign-owned U.S. bank holding  companies relying on a capital exemption (until it is eliminated).requires subsidiary institutions that fall within the defined entities subject  to OCC’s Basel III capital rules to comply with the rules, regardless of  whether they are a subsidiary of a foreign banking entity. Similarly, FDIC  requires subsidiary institutions that fall within the defined entities subject  to Basel III capital rules to comply with those rules, regardless of whether  they are a subsidiary of a foreign banking entity.
This includes subsidiaries regulated under U.S. Basel III capital regulations whether or  not those subsidiaries will be located within a U.S. intermediate holding company.
section_title: Market Participants and Observers Have Identified Some Basel III Implementation Differences between Jurisdictions but the Competitive Effects Are Unclear
paragraphs: Although the Basel capital standards serve to harmonize capital  regulations internationally, there are limitations to full harmonization. The  Basel capital standards have no legal force; rather, the Basel Committee  members developed and agreed to the standards, with the expectation  that each member will implement them. According to the Basel  Committee, it encourages convergence towards common standards and  monitors their implementation, but does not attempt detailed  harmonization of members’ supervisory approaches. The standards are  minimum requirements, and members may adopt more stringent  standards. Moreover, as jurisdictions amend their laws or regulations (or  both) to implement the Basel III standards, they will need to fit the  standards within their existing legal framework, regulatory system, or  industry structure. As the Basel capital standards periodically have been  revised and implemented, regulators, banks, and others have raised  concerns about regulatory differences between jurisdictions and their  possible competitive effects. For example, in 2007 and 2008, we reported  on such concerns arising from the U.S. implementation of Basel II.
Importantly, internationally active banks can be subject not only to their  home-country Basel III regulations but also their host-country Basel III  regulations, such as through their foreign subsidiaries. As a result, such  banks may need to create systems that take into account different  regulatory regimes and approaches. However, according to four G-SIBs  we spoke with, all transactions completed by an internationally active  bank are consolidated ultimately at the parent company for capital  purposes. In turn, the parent company must calculate its capital ratios  based on its home-country’s capital regulations. If Basel III regulations  are more stringent in the United States than in other countries,  internationally active U.S. banks could be required to hold higher levels of  regulatory capital than their foreign counterparts, and banks and some  law firms have noted that this could potentially put internationally active  U.S. banks at a competitive disadvantage. However, regulators and some  academics have noted that enhanced capital requirements could  decrease systemic risk in the banking system or increase investor  confidence, potentially providing banks holding relatively more capital with  a competitive advantage.
Although Basel III implementation is ongoing and will not be completed  for years, some banks, regulators, and law firms (in publications we  reviewed) have identified a number of implementation differences  between jurisdictions that may create competitive disparities. Many of  these differences have resulted from jurisdictions imposing more stringent  requirements than the Basel III minimum standards, which could put their  banking organizations at a competitive disadvantage. Basel III’s  implementation is a multistep process that includes the adoption of the  standards by jurisdictions through changes in law or regulations,  compliance with the law or regulations by market participants, and the  oversight and supervision of the laws or regulations by national  regulators. To date, differences initially identified by market participants  and observers have focused on the different ways that jurisdictions have  adopted the standards in their regulations, including the following:
Additional capital buffers: The Swiss Financial Market Supervisory  Authority designed its capital regulations to impose a variable  progressive capital buffer of up to 6 percent of risk-weighted assets on  two Swiss G-SIBs. The overall higher capital requirements reflect the  regulator’s prudential philosophy that Switzerland’s capital adequacy  regulations should go beyond the international minimum standards.  As UBS reported in its 2013 annual report, this requirement could  harm Swiss banks when they compete against peer financial  institutions subject to more lenient regulation. Similarly, the Bank of  England’s Prudential Regulation Authority plans to implement a firm- specific buffer that could require certain banks to hold regulatory  capital above the Basel III framework’s minimum standards.
Credit valuation adjustment: Basel III included a new capital charge  (the credit valuation adjustment) under which a bank must hold  additional capital when entering into an over-the-counter derivatives  transaction not cleared through a central counterparty. According to  market participants we interviewed and law firm documents, the EU  has diverged from Basel III (and the U.S. adoption of Basel III) by  exempting transactions from the capital charge where such  transactions are between EU-based banks and a nonfinancial  corporate, sovereign, or for a limited period, pension fund. According  to officials from three G-SIBs we interviewed, the exemption enables  European banks to price derivative transactions to such  counterparties more favorably than their non-EU competitors. Officials  from one of the banks told us that the price difference could be a key  factor in determining if customers transacted with U.S. versus  European banks, but price was not necessarily the only factor that  customers considered.
Enhanced supplementary leverage ratio: U.S. banking regulators  established a minimum supplementary leverage ratio of 3 percent for  advanced approaches banks, consistent with Basel III. However, the  regulators established an enhanced supplementary leverage ratio for  top-tier bank holding companies with more than $700 billion in total  consolidated assets or more than $10 trillion in assets under custody  and in their subsidiary depository institutions. This enhanced ratio  raised the standards above the Basel III minimum standards. Under  the final rule, such subsidiary insured depository institutions must  maintain an enhanced supplementary ratio of at least 6 percent to be  well capitalized under the prompt corrective action framework, and the  bank holding companies must maintain a buffer of more than 2  percent above the minimum supplementary leverage ratio  requirement of 3 percent to avoid restrictions on capital distributions  and discretionary bonus payments. According to an industry  association and bank we interviewed, the leverage requirement will  disadvantage such U.S. banking organizations by requiring them to  maintain higher capital than their competitors in other jurisdictions.  However, U.S. banking regulators view a strong regulatory capital  base as a competitive strength for banking organizations, rather than  a competitive weakness.
Collins Amendment: In the U.S. Basel III capital regulations, federal  banking regulators implemented section 171 of the Dodd-Frank Act  (the Collins Amendment) which requires advanced approaches  banking organizations to calculate their risk-based capital ratios under  both the advanced approaches and the standardized approach  (minimum risk-based capital requirements), among other capital  requirements. The banks then must use the lower of each capital ratio  to determine compliance with minimum capital requirements.  According to a law firm’s analysis, the rule eliminates capital relief that  large U.S. banks might otherwise obtain using their internal models  under the advanced approaches and may provide certain  internationally active foreign banks with a competitive advantage.  Additionally, officials from three U.S. G-SIBs generally told us that the  Collins Amendment could require them to hold more regulatory capital  than their foreign competitors and put them at a competitive  disadvantage.
Liquidity coverage ratio: Basel III includes the liquidity coverage  ratio as an internationally harmonized quantitative liquidity standard,  with the goal of promoting the short-term resilience of the liquidity risk  profile of internationally active banking organizations. Although at the  time we spoke with the G-SIBs, U.S. banking regulators had not  finalized their proposed rule implementing Basel III’s liquidity  coverage ratio, officials from four G-SIBs said the proposed rule  included requirements more stringent than the Basel III liquidity  standards, including a narrower range of assets that qualified as high- quality liquid assets and a faster assumed rate of outflows for  wholesale funding. They said the rule, as proposed, would require  them to hold more liquid assets than their foreign competitors, which  would be more costly for them. The U.S. banking regulators noted in  the proposed rule and final rule that there were modifications to Basel  III’s liquidity coverage ratio to reflect characteristics and risks of  specific aspects of the U.S. market. For instance, the proposed and  final rules both recognized the strong liquidity positions U.S. banking  organizations already achieved and discussed the need to maintain  that improved liquidity through the use of shorter transition periods  than mandated in Basel III. The proposed and final rule also differed  from Basel III in the method for calculating total net cash outflows;  regulators described the difference as necessary because the change  would allow companies to better capture their own liquidity risk.
In addition to differences in Basel III regulations between jurisdictions,  officials from two G-SIBs noted potential inconsistencies in the oversight  and supervision of Basel III regulations. For example, such officials said  that U.S. regulators have been more rigorous in their review and approval  of internal models used by advanced approaches banks for calculating  their risk weights under Basel II, as demonstrated by the long time it has  taken these banks to pass their parallel run under the Basel II regulations.
In contrast, banks in the EU, Canada, and Japan had begun  implementing Basel II in 2008. At that time, the EU implementation of  Basel II ahead of the United States raised competitive concerns because  of the potential for EU banks to be required to hold less regulatory capital  to support the same level of assets. Basel Committee and other studies  indicated that U.S. banks tended to be subject to higher risk weights than  EU banks, in part due to their use of the Basel I and Basel II frameworks,  respectively. At the same time, comparing risk weights across banks is  difficult, in part because of differences in business mix, accounting rules,  off-balance sheet assets, and approaches for calculating risk-weighted  assets.
While differences exist in the implementation of Basel III between  jurisdictions, the extent to which these differences collectively will affect  competition among internationally active banks is unclear. As shown in  table 7 above, Basel Committee member jurisdictions have not finished  adopting regulations to implement Basel III capital, leverage, and liquidity  standards. Moreover, the identified implementation differences cover  multiple jurisdictions and apply to different aspects of Basel III,  confounding their potential effect on competition. According to officials  from two G-SIBs, it is very difficult or impossible to measure quantitatively  the effect of such differences on competition. In addition to regulatory  capital requirements, other factors can affect the competitive position of  internationally active banks, such as differences in accounting treatment,  cost of capital, tax rules, and other regulations from one country to  another. For example, the spread or fee that banks charge for a financial  product is a function not only of their regulatory capital requirements but  also their cost of capital, which is driven by a variety of factors, and tax  rates. Additionally, officials from three G-SIBs told us the Dodd-Frank Act  and other reforms could affect the extent to which Basel III can help  provide a level playing field. For example, they said that their minimum  regulatory capital ratios effectively are set under the annual CCAR, which  has resulted in regulatory capital ratios higher than the Basel III minimum  ratios. They also said that the EU has been adopting similar stress tests  for EU banks.
section_title: Agency Comments
paragraphs: We provided a draft of this report to FDIC, Federal Reserve, and OCC for  their review and comment. FDIC, the Federal Reserve, and OCC  provided technical comments that we incorporated as appropriate.
We are sending copies of this report to the appropriate congressional  committees and the Chairman of FDIC, Chairman of the Federal Reserve,  and Comptroller of OCC. This report will also be available at no charge on  our website at http://www.gao.gov.
If you or your staff have any questions about this report, please contact  me at (202) 512-8678 or evansl@gao.gov. Contact points for our Office of  Congressional Relations and Public Affairs may be found on the last page  of this report. Key contributors to this report are listed in appendix III.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: This report examines how (1) U.S. Basel III capital may affect U.S.  banking organizations, including smaller banking organizations, and (2)  implementation of Basel III’s capital and other standards by different  jurisdictions may affect the ability of U.S. banking organizations to  compete internationally.
To assess how the U.S. Basel III capital regulation may impact U.S.  banking organizations, including smaller organizations, we used data  from the Consolidated Financial Statements for Holding Companies– Form FR Y-9C (Y-9C) and from the Consolidated Reports of Condition  and Income (Call Reports) as of March 31, 2014, to estimate (1) the  number of bank holding companies and depository institutions with capital  ratios greater than or equal to Basel III minimum capital ratios; (2) the  amount of capital bank holding companies and depository institutions  would need to meet the U.S. Basel III minimum capital requirements; and  (3) the change in funding costs for bank holding companies and  depository institutions associated with the amount of capital they would  need to meet the minimum capital requirements. We assessed the  reliability of the data from the Y-9Cs and Call Reports for these purposes  by reviewing relevant documentation and by electronically testing the data  for missing or incorrect values and for outliers. For more information on  our methodology, our results, and the limitations of our analysis, see  appendix II.
To understand how the higher capital requirements might affect the cost  and availability of credit in terms of three outcomes—the cost of capital to  banks, the interest rate paid by borrowers, and the quantity of loans by  banks, we conducted a literature survey of recent economic studies that  examined the effect of higher capital requirements on these three  outcomes. To identify relevant empirical studies, we conducted searches  of two databases, (ProQuest and EconLit) and identified and selected  economic studies from peer-reviewed journals and working papers from  governmental institutions that were published from 2011 through 2014.  We used search terms for selecting the studies, such as interest rate  spread, credit availability, cost of capital, and partial equilibrium. For  articles with abstracts, two team members independently reviewed each  abstract to determine if the article addressed the previously identified  topics and appeared to contain empirical data. If both reviewers agreed  that the article was relevant, it was saved for further review. When  reviewers disagreed, a third team member reviewed the abstract and  made the final decision. The selected studies then were evaluated to  determine if the methods were appropriate or sufficiently rigorous. A GAO  economist performed a secondary review and confirmed that the methods  met our criteria for methodological quality and were sufficiently rigorous to  assess estimates of the cost and availability of capital. Based on our  selection criteria, we identified 11 studies. One analyst then performed an  in-depth review of the findings and summarized the research in a data  collection instrument that captured the title, authors, outcomes of interest  and key findings. A GAO economist performed a secondary review and  confirmed our reported understanding of the findings. For a complete list  of the studies, see the Bibliography.
To assess the short-run impact on the cost and availability of credit of  bank holding companies or depository institutions raising capital, we used  estimates of changes in loan volumes and loan spreads associated with  changes in capital from our prior work together with our estimates of the  capital shortfall described above. To assess the long-run impact, we  used an existing loan pricing model together with our estimates of the  changes in funding costs described above.
In addition, we judgmentally selected eight community banks based on  their total assets and geographic locations and interviewed them to obtain  their views on the impact of the U.S. Basel III capital regulations on their  compliance costs and credit availability. We defined a community bank as  a subsidiary bank with $10 billion or less in assets as of December 31,  2013. Although no commonly accepted definition of a community bank  exists, this size-based definition has been used by the Board of  Governors of the Federal Reserve System (Federal Reserve). Using the  SNL database, we developed a list of 5,849 subsidiary banks with assets  of less than $10 billon. We then placed the community banks into one of  the following four asset categories: (1) $1 to less than $500 million, (2)  $500 million to less than $1billion, (3) $1 billion to less than $5 billion, and  (4) $5 billion to less than $10 billion. Based on the U.S. Census  classification, we further placed the community banks into one of the  following four regions (1) East, (2) Midwest, (3) South, and (4) West.  Within the categories of region and asset size, we randomly selected 10  banks. We assumed that a sample with a mix of different bank sizes and  geographic areas would provide a wide range of views and experiences.  Nonetheless, the information collected from this sample of banks cannot  be generalized to the larger population of all community banks. To ensure  that we captured the views of banks that are most prevalent in this  population (banks with smaller asset sizes) as well those from asset  categories that have a larger share of total assets (banks with larger  asset sizes), we attempted to select at least four banks from the lower  two asset categories and four banks from the upper two asset categories.  We also attempted to include in our sample at least two from each region  while allowing for an additional bank in two regions with a larger number  of community banks. In three cases, we were unable to make contact with  the sampled bank, so we randomly selected a substitute from the same  region and asset category. One bank merged with another, but we  retained the merged bank for our sample since it was in the same region  and asset category as the bank we originally selected. In two cases, we  were unable to make contact with or gain the participation from the  originally selected banks or with multiple numbers of randomly selected  substitute banks. As a result, the final sample consists of eight banks with  only one bank in the East.
To determine the extent to which jurisdictional differences in  implementation of Basel III’s standards may affect how various U.S.  banking organizations compete, we judgmentally selected and  interviewed 10 global systemically important banks (G-SIBs) operating in  the United States, European Union, and Japan to obtain their views on  the competitive differences resulting from implementation of the Basel III  framework across jurisdictions. To better understand the connection  between international competition and jurisdictional differences in  implementation we reviewed law firm legal briefs and client documents,  the academic literature on the role capital plays in bank competition,  publicly available consulting firm documents, and annual reports and  filings issued by publicly trading banking organizations. We also reviewed  prior GAO reports and studies on competition issued by the banking  regulators to examine historical connections between the regulatory  environment an entity faces and its ability to compete internationally. We  reviewed the European Union’s Capital Requirements Directive IV and  the United Kingdom’s Prudential Regulation Authority Consultation Paper:  Strengthening capital standards: implementing CRD IV (August 2013).
For both objectives, we reviewed banking regulations for the U.S. Basel  III capital standards, the supplementary leverage ratio, enhanced  supplementary leverage ratio and the liquidity coverage ratio. We also  reviewed prior GAO reports, studies on the Basel III framework and  regulatory reform issued by Federal Deposit Insurance Corporation,  Federal Reserve, and Office of the Comptroller of the Currency, and law  firms, and annual reports and filings issued by publicly traded banking  organizations. We also interviewed officials from six industry associations  representing U.S. or foreign banks (or both) operating in the United  States.
We conducted this performance audit from December 2013 to November  2014 in accordance with generally accepted government auditing  standards. Those standards require that we plan and perform the audit to  obtain sufficient, appropriate evidence to provide a reasonable basis for  our findings and conclusions based on our audit objectives. We believe  that the evidence obtained provides a reasonable basis for our findings  and conclusions based on our audit objectives.
section_title: Appendix II: GAO Analyses of Basel III Minimum Capital Ratios, Capital Shortfall, and Funding Costs
paragraphs: To assess how the U.S. Basel III capital regulation may impact U.S.  banking organizations, including smaller organizations, we used data  from the Consolidated Financial Statements for Holding Companies— Form FR Y-9C (Y-9Cs) and from the Consolidated Reports of Condition  and Income (Call Reports) as of March 31, 2014, to estimate (1) the  number of bank holding companies and depository institutions with capital  ratios that are greater than or equal to Basel III minimum capital ratios; (2)  the amount of capital bank holding companies and depository institutions  would need to take actions to meet the U.S. Basel III minimum capital  requirements; and (3) the change in funding costs for bank holding  companies and depository institutions associated with the amount of  capital they would need to meet the minimum capital standards. We  assessed the reliability of the data from the Y-9Cs and Call Reports for  these purposes by reviewing relevant documentation and electronically  testing the data for missing or incorrect values and outliers. We discussed  the results of our analyses in the report’s body, but we presented only  those estimates that combined the minimum capital ratios with the capital  conservation buffer. The tables below present our results in more detail.
To estimate the number of holding companies and depository institutions  with capital ratios that are greater than or equal to Basel III minimum  capital ratios, we estimated the amounts of common equity tier 1 capital,  additional tier 1 capital, tier 1 capital, tier 2 capital, and total capital  (collectively, capital) and risk-weighted assets using the calculations  described in Schedule HC-R Parts I.B and II of the Y-9C along with the  instructions to these parts of the Y-9C. The amounts of some balance  sheet and income statement items used to calculate the amount of capital  or the amount of risk-weighted assets cannot be observed for bank  holding companies or depository institutions that are not subject to, or that  do not elect to use, the advanced approaches rule. We made  assumptions about these unobservable amounts that are similar to  assumptions made by the Federal Reserve Board and for a comparable  analysis. We separated bank holding companies and depository  institutions into groups based on their size measured in total assets and  on their status as an advanced approaches holding company (for bank  holding companies) or a subsidiary of an advanced approaches holding  company (for depository institutions). The groups of bank holding  companies we analyzed are those with $500 million to less than $1 billion in assets, $1 billion to less than $10 billion in assets, $10 billion to less than $50 billion in assets, $50 billion or more in assets but not using the advanced approaches $50 billion or more in assets and using the advanced approaches.
The groups of depository institutions we analyzed are those with  less than $1 billion in assets, $1 billion to less than $10 billion in assets, $10 billion to less than $50 billion in assets, $50 billion or more in assets, and  those that are subsidiaries of advanced approaches holding  companies (regardless of their size).
We used our estimates of the amounts of capital and risk-weighted assets  to estimate the ratios of common equity tier 1 capital to risk-weighted  assets, tier 1 capital to risk-weighted assets, total capital to risk-weighted  assets, and tier 1 capital to average assets for each bank holding  company and depository institution. We then compared the estimated  capital ratios to the Basel III minimum capital ratios, both with and without  the capital conservation buffer, and counted the numbers of bank holding  companies and depository institutions with estimated capital ratios that  met and did not meet the Basel III minimum capital ratios.
To estimate the amount of capital bank holding companies and depository  institutions would need to raise to meet U.S. Basel III capital  requirements, we calculated the amount of capital required to meet the  U.S. Basel III minimum (the capital shortfall), in billions of dollars and as a  percentage of total assets for each capital ratio, for bank holding  companies and depository institutions with capital ratios less than the  Basel III minimums. For each capital ratio, we then calculated the median  capital shortfall for bank holding companies and depository institutions  with insufficient capital relative to the Basel III minimums. For each capital  ratio, we also calculated the total capital shortfall for all bank holding  companies and depository institutions with insufficient capital in billions of  dollars and as a percentage of the total assets of all bank holding  companies and depository institutions we analyzed.
To estimate the change in funding costs for bank holding companies and  depository institutions that need to raise capital, we first estimated the  change in funding cost per dollar of assets associated with a 1  percentage point increase in the ratio of equity capital to assets by  calculating the difference between return on equity and the after-tax  interest rate on debt. We used the median return on equity (net income as  a percentage of equity capital) and the median interest rate on debt  (interest expense as a percentage of interest-bearing liabilities) for each  group of bank holding companies and depository institutions for the first  quarter of 2014, and we assumed that the marginal corporate income tax  rate equaled 35 percent. For bank holding companies and depository  institutions of different sizes and different status (as advanced  approaches holding companies or subsidiaries of advanced approaches  holding companies) and with capital ratios less than the Basel III  minimums, we estimated the median change in funding cost associated  with raising capital sufficient to meet the Basel III minimums by  multiplying the median capital shortfall as a percentage of assets by the  estimated change in funding cost.
Our estimates of the numbers of bank holding companies and depository  institutions with capital ratios exceeding Basel III minimums and of the  capital shortfall are subject to limitations. Most importantly, the amounts  of some balance sheet and income statement items used to calculate the  amount of capital or the amount of risk-weighted assets cannot be  observed for bank holding companies or depository institutions that are  not subject to or that do not elect to use the advanced approaches rule.  We made assumptions about these unobservable amounts that are  similar to assumptions the Board of Governors of the Federal Reserve   However, we cannot assess  System made for a comparable analysis.the extent to which our estimates overstate or understate the numbers of  bank holding companies and depository institutions that already met  Basel III capital standards or the capital shortfall. In addition, some bank  holding companies and depository institutions may want to maintain a  capital in excess of the regulatory minimum levels to satisfy investors or  other market participants. In this case, our estimates likely understate the  number of bank holding companies and depository institutions that will  raise capital and also understate the amount of capital raised.
Our estimates of the increase in funding costs associated with raising  capital also are subject to several limitations. First, as we discuss above,  our estimates of the capital shortfall are subject to limitations and may  overstate or understate the amount of capital that bank holding  companies and depository institutions raise in response to the new Basel  III standards. Because the increase in funding costs is related to the size  of the capital shortfall, our estimates of the increase may be overstated or  understated. In particular, some bank holding companies or depository  institutions may maintain capital in excess of the minimum requirements  (a capital buffer). The larger the capital buffer, the more funding costs will  increase and the more our estimates will understate them. In addition, our  estimates reflect the median amounts of capital required by bank holding  companies and depository institutions we estimated to have insufficient  capital to meet Basel III standards, may not reflect the specific  circumstances of an individual bank holding company or depository  institution that may need to raise capital, and may overstate or understate  the change in its funding cost. Furthermore, our estimates reflect the  median return on equity and interest rate on debt that prevailed in the first  quarter of 2014, as well as our assumption of a corporate income tax rate  of 35 percent. However, equity returns, debt interest rates, and tax rates  may change, altering the relative prices of debt and equity and thus  altering the change in funding costs associated with substituting equity for  debt. Finally, our estimates assume that the return on equity will not  change when a bank holding company or depository institution increases  its capital ratio. However, increasing reliance on equity funding reduces  the risks to investors, all else being equal. If a bank holding company or  depository institution increased its ratio of capital to assets, then the  return on its equity could fall as investors demanded less of a risk  premium.
subsections: section_title: Analysis of Basel III Minimum Capital Ratios
paragraphs: We used our estimates of the amounts of capital and risk-weighted assets  to estimate the ratios of common equity tier 1 capital to risk-weighted  assets, tier 1 capital to risk-weighted assets, total capital to risk-weighted  assets, and tier 1 capital to average assets for each bank holding  company and depository institution. We then compared the estimated  capital ratios to the Basel III minimum capital ratios, with and without the  capital conservation buffer, and counted the numbers of bank holding  companies and depository institutions with estimated capital ratios that  met and did not meet the Basel III minimum capital ratios. Our estimates  are presented in table 8.
section_title: Analysis of Capital Shortfall
paragraphs: For bank holding companies and depository institutions with capital ratios  less than the Basel III minimums, we calculated the amount of capital  required to meet the Basel III minimums (the capital shortfall), both in  billions of dollars and as a percentage of total assets. For each capital  ratio, we then calculated the median capital shortfall for bank holding  companies and depository institutions with insufficient capital relative to  the Basel III minimums. Our estimates are presented in table 9.
For each capital ratio, we also calculated the total capital shortfall for all  bank holding companies and depository institutions with insufficient  capital in billions of dollars and as a percentage of the total assets of all  the bank holding companies and depository institutions we analyzed. Our  estimates are presented in table 10.
section_title: Analysis of Funding Cost Associated with the Capital Shortfall
paragraphs: For bank holding companies and depository institutions of different sizes  and different status as advanced approaches holding companies or  subsidiaries of advanced approaches holding companies, we estimated  the change in funding cost per dollar of assets associated with a 1  percentage point increase in the ratio of equity capital to assets. Funding  costs are determined by the prices of equity and debt financing sources  and the amounts used of each. Because interest payments on debt are  tax-deductible, a more leveraged capital structure reduces corporate  taxes, lowering funding costs. Thus, an increase in the required amount  of equity capital would increase a bank’s cost of capital. The increased  funding cost associated with a 1 percentage point increase in the capital  ratio of a bank holding company or depository institution is approximately  equal to the difference between the return on equity and the after-tax  interest rate on debt, all else being equal. We used the median return on  equity (net income as a percentage of equity capital) and the median  interest rate on debt (interest expense as a percentage of interest-bearing  liabilities) for each group of bank holding companies and depository  institutions for the first quarter of 2014, and we assumed that the marginal  corporate income tax rate is equal to 35 percent. Our estimates are  presented in table 11.
For bank holding companies and depository institutions of different sizes  and different status as advanced approaches holding companies or  subsidiaries of advanced approaches holding companies and with capital  ratios less than the Basel III minimums, we estimated the median change  in funding cost associated with raising capital sufficient to meet the Basel  III minimums by multiplying the median capital shortfall as a percentage  of assets by the estimated change in funding cost. Our estimates are  presented in table 12.
section_title: Appendix III: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact name above, Richard Tsuhara (Assistant  Director), Nancy Eibeck (Analyst-in-Charge), Jessica Artis, Chloe F.  Brown, Pamela R. Davidson, Donald P. Hirasuna, Courtney L.  LaFountain, Jon D. Menaster, Marc W. Molino, Barbara M. Roesmann,  and Jessica M. Sandler made significant contributions to this report.
section_title: Bibliography
paragraphs: We reviewed 11 recent empirical studies (published from 2011 through  2014) that examined how higher capital standards might affect the cost  and availability of credit in terms of three outcomes—the cost of capital to  banks, the interest rate paid by borrowers, and the quantity of loans by  banks.
Agenor, Pierre-Richard, Koray, Alper, and Luiz Pereira da Silva. “Capital  Regulation, Monetary Policy, and Financial Stability.” International Journal  of Central Banking, vol. 9, no. 3 (September 2013).
Baker, Malcolm, and Jeffrey Wurgler. “Do Strict Capital Requirements  Raise the Cost of Capital? Banking Regulation and the Low Risk  Anomaly.” National Bureau of Economic Research working paper 19018  (May 2013).
Cosimano, Thomas F., and Dalia S. Hakura. “Bank Behavior in Response  to Basel III: A Cross-Country Analysis.” International Monetary Fund  working paper 11-119 (May 2011).
Corbae, Dean, and Pablo D’Erasmo. “Capital Requirements in a  Quantitative Model of Banking Industry Dynamics”. Federal Reserve Bank  of Philadelphia working paper 14-13 (April 2014).
Gauthier, Céline, Alfred Lehar, and Moez Souissi. “Macroprudential  Capital Requirements and Systemic Risk.” Journal of Financial  Intermediation, vol. 21, no. 4 (October 2012).
Martın-Oliver, Alfredo, Sonia Ruano, and Vicente Salas-Fumas. “Banks’  Equity Capital Frictions, Capital Ratios, and Interest Rates: Evidence from  Spanish Banks.” International Journal of Central Banking, vol. 9, no. 1  (March 2013).
Paries, Matthieu Darracq, Christoffer Kok Sørensen, and Diego  Rodriguez-Palenzuela. “Macroeconomic Propagation under Different  Regulatory Regimes: Evidence from an Estimated DSGE Model for the  Euro Area.” International Journal of Central Banking, vol. 7, no. 4  (December 2011).
Roger, Scott, and Francis Vitek. “The Global Macroeconomic Costs of  Raising Bank Capital Adequacy Requirements.” International Monetary  Fund working paper 12-44 (February 2012).
Slovik, Patrick, and Boris Cournède. “Macroeconomic Impact of Basel III.”  Organisation for Economic Co-operation and Development Economics  Department working paper 844 (February 14, 2011).
Šutorova, Barbora, and Petr Teply. “The Impact of Basel III on Lending  Rates of EU Banks.” Czech Journal of Economics and Finance, vol. 63,  no. 3 (2013).
Yan, Meilan, Maximilian J.B. Hall, and Paul Turner. “A Cost–Benefit  Analysis of Basel III: Some Evidence from the UK.” International Review  of Financial Analysis, vol. 25 (December 2012).