Chart: Why Basel III Matters – Citigroup Inc. (C), JPMorgan Chase & Co. (JPM)

This is slightly esoteric, but nevertheless extremely important for bank investors to understand.

At the end of 2010, the Basel Committee on Banking Supervision, an international consortium of banking regulators, finalized an updated set of guidelines for determining how much capital banks should be required to hold relative to the size of their balance sheets.

Prior to the updated regulatory scheme, the largest banks in the United States were obligated to maintain a Tier 1 common capital ratio of 5% (relative to risk-weighted assets) under the Federal Reserve’s Comprehensive Capital Analysis and Review, or “CCAR” — the formal process used by the central bank to ensure that large bank holding companies have adequate capital and capital-management procedures in place.

Citigroup Inc (NYSE:C)Under Basel III, this minimum requirement increases dramatically. When fully phased in, Basel III requires bank holding companies to maintain a minimum ratio of Tier 1 common capital to risk-weighted assets of at least 7%, consisting of a minimum ratio of 4.5% plus a 2.5% “capital conservation buffer.” In addition, the Basel Committee has proposed a surcharge for systematically important financial institutions — i.e., too big to fail — of between 1% and 3.5%, depending on the nature of the underlying operation.

Here’s how the latter so-called “SIFI buffer” plays out for the largest U.S. banks:

Bank Holding Company SIFI Buffer Tier 1 Capital Requirement
Citigroup Inc. (NYSE:C) 2.5% 9.5%
JPMorgan Chase & Co. (NYSE:JPM) 2.5% 9.5%
Bank of America Corp (NYSE:BAC) 1.5% 8.5%
Bank of New York Mellon 1.5% 8.5%
Goldman Sachs (NYSE:GS) 1.5% 8.5%
Morgan Stanley 1.5% 8.5%
State Street 1% 8%
Wells Fargo & Co (NYSE:WFC) 1% 8%

Source: Financial Stability Board’s “Update of group of global systematically important banks.”

As you can see, while global banks like Citigroup Inc. (NYSE:C) and JPMorgan Chase & Co. (NYSE:JPM) were previously obligated to hold 5% in Tier 1 common capital relative to risk-weighted assets, they must now hold 9.5%, or nearly twice the previous amount. And even primarily domestic operations like B of A and Wells Fargo see their rates ratchet up by 1.5% and 1%, respectively. To make matters worse (at least from a bank’s perspective) the Basel Committee made the risk-weighting of assets a more exclusive process. The net effect is to increase the denominator in the capital equation, which puts downward pressure on the quotient — that is, the ratio itself. Taken together, banks will be much more limited in terms of leverage going forward.

To make this easier to visualize, I created the following chart, which compares how much Tier 1 common capital B of A is obligated to hold under the current rules relative to how much it holds under the Basel III guidelines.