By Steven K. Beckner

WASHINGTON (MNI) – New York Federal Reserve Bank President William
Dudley downplayed the economic impact of the higher capital standards
that will be phased in in coming years under a recent international
agreement reached in Basel, Switzerland in a Sunday morning speech.

Dudley, in remarks prepared for the Institute of International
Finance, said the potential costs of the more demanding “Basel III”
capital requirements has been “exaggerated.” He also doubted whether
they will force banks to increase lending spreads as much as some have
predicted.

He said the new capital accord strikes the right balance between
the needs for large financial institutions to have a stronger capital
base and the needs of the economy for credit.

“Some argue that the new standards are too severe,” Dudley
noted. “They argue that, in the short run, the higher standards could
lead to a significant constraint in credit that could hurt the nascent
economic expansion. And, they argue, in the long run, that the higher
capital standards will inevitably drive up lending costs and that this
will hurt economic performance.”

Dudley demurred. “Although I believe the new standards do impose
some real costs on the financial system in order to achieve real
benefits, I believe that concerns over the costs are exaggerated.”

He said he “cannot precisely predict the size of the adjustment
costs as they will depend importantly on the strategies bank managers
employ to meet the new requirements, and how bank investors respond to
these actions.”

“Nonetheless,” he added, “I believe the transition is likely to be
quite manageable for three reasons:

* “First, many of the large U.S. banks already have large amounts
of tangible common equity” as a result of last year’s “stress tests” on
the 19 biggest banks.

* “Second, … the standards are being phased in slowly. For
example, in 2013, the tangible common equity standard will be only 3.5%.
In 2013, there will be no conservation buffer requirement and banks will
still get credit for items that will ultimately be deducted from common
equity, such as deferred tax assets….

* “Third, banks have many ways they can adjust their business
models to meet the new standards as they are phased in. Many of these
changes can occur without any risk of disruption to the flow of credit
to households and business. For instance, banks can sell non-strategic
assets to investors and can modify their minority investments in
non-consolidated interests.”

Dudley said he “expects” that banks will ulimately meet or exceed
the 7% common equity limit, which is the sum of the minimum requirement
and a “conservation buffer.”

But he said, “we do anticipate that the buffer may be penetrated
from time to time during adverse economic environments.”

Dudley also addressed concerns that Basel III could cause banks to
widen lending spreads — the difference between their cost of funds and
their lending rates — to generate additional capital. He didn’t dispute
that this will happen, but suggested that the spread widening will not
be large.

“It would be prudent to assume that requiring banks to hold more
capital and higher cost capital is likely to result in somewhat higher
lending spreads,” he acknowledged. “Bank managements will need to
generate sufficient income to support the rate of return on equity at a
sufficient high level so banks can continue to attract capital from
investors.”

But he said “those who argue that the new capital standards will
necessitate a large increase in lending spreads generally start with a
rigid set of assumptions.”

Those betting on large increases in spreads assume 1. “return on
bank equity is unchanged; 2) the increase in bank equity does not affect
funding costs; and 3) there is no change in the banks’ book of business
or on banks’ ability and willingness to adjust other expenses, such as
compensation.”

Dudley said “such rigid assumptions are unrealistic” and said “this
is particularly important because each assumption is likely to be wrong
in the direction that reduces the impact on lending margins.”

“First, the necessary return on equity that banks will have to
generate to be able to attract capital will likely fall,” he said.
“Because banks with more capital should be safer and have less volatile
earnings, investors should demand a lower return on equity than before.”

“Second, by increasing the soundness of banks, an increase in bank
equity, everything else equal, should also reduce funding costs,” he
contended. “Third, higher bank lending spreads almost certainly will
push some activity into the capital markets, constraining the magnitude
of the rise in total lending costs.”

“Finally, banks may be forced via competitive pressures to lower
their compensation levels,” he continued. “By cutting compensation
costs, banks could have smaller lending margins and still earn
sufficient profits to generate a level of returns necessary to attract
capital.”

“Given all the potential margins for adjustment, there are good
reasons to expect that the increase in lending margins will actually
turn out to be quite modest,” he added.

Dudley conceded that “any increase will be a real cost,” but he
said “this appears to be a necessary and appropriate price to pay for a
much more resilient financial system.”

“The cost represented by higher lending spreads has to be weighed
against the benefits of a more robust and resilient banking system,” he
said.

Dudley said “the biggest lesson of the financial crisis is that
severe financial disruptions can inflict very large and persistent costs
on real economic activity and employment.” And so “lawmakers and
regulators must make widespread changes to create a more resilient and
robust global financial system.”

“But, at the same time, this must be done in way that ensures the
financial system retains sufficient dynamism so that it can allocate
capital efficiently to support innovation and economic growth,” he said.

The Basel III capital and liquidity standards accomplish this goal,
according to Dudley.

“I believe these standards address some of the major shortcomings
revealed by the crisis…,” he said. “(T)he new standards will require
banking organizations to significantly increase the amount of
high-quality, loss-absorbing capital that they hold; significantly
improve risk capture in trading, counterparty credit, securitization and
other activities that the prior regulatory capital requirements did not
adequately capture; make it more expensive for banks to provide
liquidity guarantees to shadow banks; constrain the leverage that
banking companies can take by introducing a credible, non-risk-based
backstop; and increase the capacity of banks to absorb shocks that might
temporarily impede their ability to access short-term funding
markets….”

Dudley said the agreement “achieves an appropriate balance between
significantly increasing the minimum capital and liquidity requirements
for the major banks, while doing so in a way that recognizes the current
state of the global economy and that seeks to minimize adjustment
costs….”

** Market News International Washington Bureau: 202-371-2121 **

[TOPICS: M$U$$$,MMUFE$,MGU$$$,MFU$$$,M$$BR$]