Just as were going to press with the following discussion of a Senate hearing into proposed bank capital rules, the U. S. Treasury Department announced its exemption of foreign exchange forwards and swaps from the definition of the term “swap” in the Commodity Exchange Act. We know that will be of great interest to our investment management clients. Now back to bank regulation.

Last June, the Federal bank regulators proposed approximately 750 pages of new capital rules to implement both the recommendations (“Basel III”) of an international committee of bank regulators as well as the Dodd-Frank Act. On Wednesday, November 14, a panel of bank regulators testified at a hearing into those proposed capital rules, held by the U.S. Senate Banking Committee. A panel of bank regulators testified. While the Senators asked many of what some believe are the right questions, the regulators' responses were generally that they will carefully review the more than 1,500 comment letters filed on the proposed rules.

In their direct testimony, the regulators explained that the recent financial crisis demonstrated that some banking organizations had not held enough capital and that some capital instruments were unable to absorb losses. The proposed rules, they explained, would make capital requirements more sensitive to a bank's risk profile and also improve the quality of capital. They also indicated that the vast majority of banking organizations already meet the higher proposed capital standards specifically noting that 90% of community banks do so.

The Senators asked about concerns of community banks, such as that the new rules will discourage balloon and second mortgages in rural areas by increasing the amount of capital to be held against such loans and that the new rules will increase volatility of capital as the amount of required capital will be affected by changes in interest rates. The regulators responded that they take these concerns seriously.

The Senators also asked about applying capital requirements to insurance firms that own savings banks, and the Federal Reserve witness assured the Senators that it has been consulting with insurance experts and state insurance regulators.

The regulators did not answer questions as to when final rules would be issued or what their effective dates would be, but responded that the proposed rules are complex and that comments will be taken into consideration. The agencies had initially proposed a January 1, 2013 effective date, but have now delayed it. In any event, some aspects of the proposed rules have lengthy transition periods.

In response to a question whether the framework over-relies on models assessing risk of particular assets, the Federal Reserve witness noted that capital would also need to be maintained against non-risk-weighted total assets in the form of a leverage ratio which would provide some protection against gaming with models. Another Senator noted that commenters have suggested that the leverage ratio for the largest banks may be too low. The Federal Reserve witness said it is working through those comments.

Another Senator expressed concern that sovereign debt would be treated as riskless which could incent U.S. banks to hold debt issued by Spain. The regulators answered that other tools at their disposal would prevent that.

The Senator also asked whether the regulators' detailed work on grading risk of different types of mortgages should be replicated with credit card, auto, and corporate debt, to which the regulators answered that the largest banks would be subject to more complex approaches requiring more sophisticated analysis of other debt.

Another Senator asked about compliance costs especially for systemically insignificant community banks; the FDIC witness indicated that the FDIC has analyzed those costs and is taking them into account.

In the final analysis, the Senators enunciated a number of concerns with the proposed capital rules, and the regulators' response essentially was that they are working on the matter.