U.S. Fed pledges to get tough on Wall Street as adopts Basel rules

By Douwe Miedema

WASHINGTON (Reuters) - The U.S. Federal Reserve on Tuesday pledged to draft more tough rules for Wall Street as it adopted a version of Basel III bank capital rules that would protect smaller banks from some of the harshest impact of the new regime.

The central bank voted in favor of the long-awaited U.S. version of the international Basel III capital rules for banks, to use more equity capital to fund their business to make them more robust after the 2007-09 credit meltdown.

The rules are not expected to cause a flurry of fund-raisings, with the Fed saying that 95 percent of bank holding companies with more than $10 billion in total assets would meet the new 7 percent common equity tier 1 threshold.

The KBW Bank Index <.BKX> of bank stocks was up almost 1 percent in early afternoon trading.

However, the Fed warned it was drafting four more rules that would go beyond what the Basel accord called for, including one on leverage and another on a capital surcharge.

In the final rule adopted on Tuesday, the Fed did provide some flexibility designed to benefit the housing recovery and smaller banks.

The final rule drops a provision from the original proposal that would have forced banks to set aside more capital to fund their residential mortgage business.

Small banks can also opt out of a costly requirement that would have forced them to adjust the value of securities in their trading book on a frequent basis.

"The headline here is (that) community banks are getting significant relief," said Allison Breault, an associate at law firm Cleary Gottlieb Steen & Hamilton in Brussels.

"The largest banking organizations are going to be subject to even stricter requirements than they had originally anticipated," she said.

The Basel III accord, named after the Swiss city that is home to its overseer, the Bank for International Settlements, forces banks to borrow less to fund their business, to reduce their risk and protect taxpayers from bailouts.

The pact, which would be phased in the coming years, would force most banks to hold about three times as much top-quality capital as is required under existing rules.

There has been rising concern among U.S. politicians that the system, under which banks can still measure risk using their own mathematical models, does not do enough to prevent a repeat from the most recent crisis.

The Fed now appears to have taken some of that on board, as Daniel Tarullo, the Fed board member in charge of financial supervision, said bank regulators are working on four new rules for the country's biggest banks in the coming months.

Much of the debate has focused on the so-called leverage ratio, which does not take into account banks' risk-weightings and is set at 3 percent in Basel, making it an unambitious goal in the eyes of many critics. Tarullo agreed.

"The Basel III leverage ratio seems to have been set too low to be an effective counterpart to the combination of risk-weighted capital measures that have been agreed internationally," he said.

Besides an additional rule on leverage, U.S. bank regulators are also working on a rule to address risks in short-term wholesale funding, a rule on combined equity and long-term debt, and a capital surcharge for banks that pose a potential threat to the entire system.

Two other U.S. bank regulators, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Company, also must approve the rules. They have scheduled meetings to do so next week.

The FDIC's second-in-command, Tom Hoenig, is an outspoken critic of Basel III, which he says allows lenders to appear well-capitalized when they are not.

He has said the rules are flawed because they give the banks latitude to use complicated measurements of how risky their loans are to determine the capital they must hold.

(Additional reporting by Margaret Chadbourn; Editing by Karey Van Hall and Chizu Nomiyama)