Big banks were warned of further government-inflicted pain, small banks won concessions and mortgage lenders were granted a reprieve as the Federal Reserve on Tuesday finalized a key rule meant to strengthen banks to guard against another near-collapse of the U.S. financial system.

The directive requires banks to more than double the amount of capital they use to fund loans and investments, reduce borrowing, and obey stricter standards when classifying the riskiness of assets such as securities and derivatives.

Big banks have to start complying in January. Smaller banks have an extra year. Some nine in 10 already meet the requirements, and those that don't collectively only have to sock away a few billion dollars in earnings over the next several quarters to meet the new rules.

Dan Tarullo, the Fed governor overseeing financial regulation, effectively notified the biggest banks -- JPMorgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, Morgan Stanley, State Street and Bank of New York Mellon -- that even tougher rules would be coming in the next few months, as the Fed taxes size and complexity in a bid to make it so expensive for banks to be big and complicated that they will voluntarily shrink and simplify their operations to forever end the perception that some are “too big to fail.”

Wells Fargo in particular may be forced to restructure its home-loan business due to an aspect of the rule that effectively penalizes banks that dominate the mortgage-servicing business. Wells Fargo is the biggest home-loan servicer. “There are a handful of firms that would have concentrations and will likely have to adjust their business models to address it,” said Connie Horsley, a top Fed official.

Tuesday’s event at the Fed’s headquarters in Washington served as a warning that even though the nation is nearly five years removed from the height of the financial crisis, regulators haven't finished reforming a sector that spawned the most punishing economic downturn since the Great Depression.

“Adoption of these rules assures that, as memories of the crisis fade, efforts to build and maintain higher capital levels will not be allowed to wane,” Tarullo said.

Jaret Seiberg, senior policy analyst at Guggenheim Securities’ Washington Research Group, was blunt in his assessment: “For the biggest banks, there is little to cheer.”

The final rule unanimously approved by the Fed’s seven-member Board of Governors formally implements the U.S. version of the Basel III bank capital accords, the third version of international standards agreed in Basel, Switzerland, by 27 countries with major financial centers. A perceived delay in finalizing Basel III, proposed in June 2012, contributed to doubts among some prominent European regulators and politicians about the U.S. commitment to the third and most recent version of Basel. The U.S. declined to fully implement Basel II.

“This framework requires banking organizations to hold more and higher quality capital, which acts as a financial cushion to absorb losses, while reducing the incentive for firms to take excessive risks,” said Ben Bernanke, Fed chairman. “With these revisions to our capital rules, banking organizations will be better able to withstand periods of financial stress, thus contributing to the overall health of the U.S. economy.”

In addition to the 2010 overhaul of financial regulation known as Dodd-Frank, the Fed’s action represents one part of a sweeping overhaul of U.S. banking rules enacted in response to the 2007-2009 financial crisis. Triggered by mortgage defaults, the crisis nearly bankrupted the nation’s biggest banks and created calls for reform ranging from stricter rules to a forced restructuring of banks such as JPMorgan and Citi.

The U.S. settled on stronger rules, part of which involves Basel and changes how banks must assess the riskiness of assets. The process -- hugely important to banks -- affects profitability and how bank executives are paid.

Banks must fund their assets with a certain amount of equity capital, adjusted for risk. Riskier assets, such as securitized private student loans, carry higher risk-weights than safer assets, such as U.S. Treasuries. Higher risk-weights demand more equity capital.

With banks’ profitability largely based on their return on equity, the more equity they’re forced to use to fund their assets, the more profit they have to generate in order to attract investors. Bank executives often are paid based on their return on equity.

Jamie Dimon, JPMorgan chief executive, said in October 2011 that in response to Basel III’s treatment of risk-weighted assets, the bank would “manage the hell out of" risk-weighted assets.

The Fed’s final rule abandoned an ambitious proposal to raise risk-weightings for home loans, citing concerns about the fragile mortgage market and how various final and proposed regulations would work together.

The Fed also scaled back for some banks a proposal governing unrealized income from mark-to-market gains and losses on debt securities that would have affected banks’ capital ratios. Banks had complained the proposal was unfair, in part because gains and losses on securities such as Treasuries are directly determined by the Fed’s monetary policy.

The Fed allowed community banks to opt out of the policy. Big banks were not spared.

The regulator, however, maintained a proposal affecting capital and mortgage-servicing rights, an asset that’s valued based on expected future proceeds from collecting monthly payments on home loans. The Fed’s rule penalizes banks that have too much, making it more expensive for them to service huge volumes of home loans.

Some regulators and Obama administration officials have said they fear the Fed’s rule will push banks to offload their businesses servicing home loans onto non-banks, further pushing mortgage servicing out of the closely regulated banking sector. The banking industry has been nearly united in opposing the provision.

The Independent Community Bankers of America, the main community-bank trade group in Washington, praised the Fed’s general approach to limiting some of the more onerous provisions, though it said it was disappointed smaller banks were not completely exempt from Basel III. Other bank representatives said the Fed went too far.

Heightened concerns voiced by representatives of big banks largely were a result of statements by Tarullo, who repeated his reservations that the current rules do not go far enough in curbing risk.

Tarullo offered four expected measures to further beef up U.S. bank capital rules, all of which he’s either explicitly mentioned in previous speeches or hinted at.

For example, the largest lenders will have to meet an enhanced leverage ratio -- which compares equity capital to total assets -- that is more strict than the Fed’s 2012 proposal and potentially goes beyond internationally-agreed standards. The Federal Deposit Insurance Corp. is due to consider a proposal next week.

Stefan Walter, former secretary general of the Basel committee, said the current U.S. proposal is much more generous to big banks than the internationally agreed standard. But if the U.S. increases the numerator in the ratio -- required equity capital -- and expands the denominator -- the amount of assets, which could be tweaked under different accounting regimes -- then the new U.S. standard would go “well beyond” the international rule, he said.

The move “could have implications for banks’ business models,” said Walter, who now serves as global bank supervisory and regulatory policy leader at EY, the accounting consultancy formerly known as Ernst & Young.

The biggest banks also have to meet an impending requirement that sets a minimum ratio of combined equity capital and long-term debt compared to assets. The proposal is meant to establish enough loss-absorbency that a giant bank could be resolved under a new and untested regime specifically for large banks that is meant to resemble the bankruptcy process, rather than resorting to taxpayer bailouts.

A third proposal relates to a so-called “surcharge” for the biggest and most complex institutions that establishes even higher capital requirements. The fourth and likely final proposal would further increase capital requirements for banks that are “substantially dependent” on short-term borrowings, rather than long-term debt or bank deposits.

“Once final, these measures would round out a capital regime of complementary requirements that focus on different vulnerabilities and together compensate for the inevitable shortcomings in any single capital measure,” Tarullo said.

Alok Sinha, a banking expert at Deloitte & Touche, said the financial industry had not anticipated more stringent rules when they were first proposed a few years ago.

“The pendulum continues to swing farther from where we expected it to be,” Sinha said. Capital requirements, he added, are “continuing to go up beyond what we thought.”

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