Treasury's new Bank Funding Standards Have Teeth

Perhaps the most salient aspect of the Treasury Department's proposed new capital and liquidity standards is that they stand a good chance of being adopted. The usual suspects will lobby to water them down. But the plan will likely muster enough congressional support to survive.

Treasury boss Tim Geithner wisely did not specify how much additional money banks will need to keep on hand. The standards only say that all banks must maintain higher capital levels, giving regulators and bankers room to haggle. Yet the agency is also demanding more from the biggest institutions.

"First, capital requirements for banks simply must be higher across the board. Bringing more capital into the banking system is vital," he said Thursday in an op-ed in the FT. "It is equally crucial to hold the largest, most interconnected institutions, whether or not they own banks, to tougher standards than others."

The heart of the proposal is making sure banks have a fat enough capital cushion to avoid the kind of massive losses that can jeopardize the entire financial system. These higher capital requirements will likely dent bank profits. That means the agency can't set the threshold so high that banks must cut interest rates to uncompetitive levels, which would drive consumers to non-bank companies for a loan.

Another important effect is that banks will have to sock away capital in both good times and bad. That's a major departure from industry norms, when institutions modulated their capital levels in tune with the business cycle's ups and downs. Treasury also wants banks to uphold the quality of their assets, another barrier against high-risk lending.

Notably, the plan also advises banks against basing their so-called capital ratios, which indicate financial stability, on internal models or credit ratings to calculate those ratios. That goes further than standards proposed as part of the the Basel II process, which aims to coordinate bank reform.

Following are the eight "core principles" Treasury outlined for banks:

• Capital requirements should be designed to protect the stability of the financial system (as well as the solvency of individual banking firms).

• Capital requirements for all banking firms should be higher, and capital requirements for Tier 1 [Financial Holding Companies] should be higher than capital requirements for other banking firms.

• The regulatory capital framework should put greater emphasis on higher quality forms of capital.

• Risk-based capital requirements should be a function of the relative risk of a banking firm's exposures, and risk-based capital ratios should better reflect a banking firm's current financial condition.

• The procyclicality of the regulatory capital and accounting regimes should be reduced and consideration should be given to introducing countercyclical elements into the regulatory capital regime.

• Banking firms should be subject to a simple, non-risk-based leverage constraint.

• Banking firms should be subject to a conservative, explicit liquidity standard.

• Stricter capital requirements for the banking system should not result in the re-emergence of an under-regulated non-bank financial sector that poses a threat to financial stability.