* Basel III calls for 7 pct ratio for top-level capital
* Each country finalizing their version of global pact
* Fed proposal does not give in to U.S. banks' requests
By Dave Clarke
WASHINGTON, June 7 (Reuters) - The Federal Reserve rejected pleas by the U.S. banking industry in releasing on Thursday a rigorous interpretation of an international agreement on higher capital standards for banks, known as Basel III.
U.S. banks have pushed the Fed, for instance, to allow them to more heavily count mortgage servicing rights and the unrealized gains and losses of certain securities toward their capital requirements than allowed by Basel III, but the U.S. central bank's draft rule closely follows the international agreement.
"Some of the major, major things the industry, particularly the big banks, were looking for it sounds to me like the Fed showed them no mercy," said Karen Petrou, managing partner of Washington-based Federal Financial Analytics.
The basics of the Fed's proposals would capture even the smallest banks, a move likely to irritate community bankers who had been hoping to escape the brunt of the new standards.
The Fed board voted 7-0 on Thursday to put the proposal out for public comment for 90 days. The Federal Deposit Insurance Corp and the Comptroller of the Currency are expected to approve the proposal soon as well.
The Basel agreement is the cornerstone of efforts by international regulators following the 2007-2009 financial crisis to make sure the global banking system is more resilient.
JPMorgan's announcement last month that a hedging strategy had gone awry, producing at least $2 billion in unexpected trading losses, has been pointed to as a reminder of the need for substantial capital cushions.
The new capital standards would force banks to rely more on equity than debt to fund themselves, so that they are able to better withstand significant losses.
The banking industry has complained that the rules could limit their ability to lend.
At Thursday's meeting Fed staff mostly dismissed this concern saying the benefit of a safer financial system far outweighed any potential decrease in lending activity.
Fed staff also said banks of all sizes should be able to meet the new requirements by retaining earnings.
The accord, which is to be phased in from 2013 through 2019, will require banks to maintain top-quality capital equivalent to 7 percent of their risk-bearing assets, about three times what they are required to hold under existing rules. The Fed proposal adheres to this standard.
It is up to each country to write rules to implement the Basel agreement for its banks.
The U.S. banking industry was not optimistic that the Fed would do major surgery to the international Basel agreement but there has been a push by lobbying groups to get regulators to at least go easy on aspects that would hit U.S. banks the hardest.
Mortgage servicing rights (MSR), for instance, are used far more by U.S. lenders than by their international competitors. Banks get paid fees for servicing a home loan, which means collecting payments and managing foreclosures, and because they can be sold in markets, their value has been allowed to count toward capital requirements.
The Basel agreement limited to 10 percent how much MSRs could count toward the common equity component and the Fed decided to strictly follow that standard.
In anticipation of the new rules, some banks have been selling off mortgage servicing rights. This week, Bank of America Corp agreed to sell $10.4 billion in mortgage servicing rights to a unit of Nationstar Mortgage Holdings Inc .
While grumbling about the details, banks have mostly agreed with the minimum capital levels required by Basel.
The biggest banks, however, have balked at a part of the agreement to have 28 global "systemic" banks hold as much as an additional 2.5 percent capital buffer.
This provision would hit the largest international financial institutions such as JPMorgan Chase & Co, Goldman Sachs Group Inc and Deutsche Bank AG.
The Fed draft proposal released on Thursday does not address the capital buffer for the largest banks; a rule is expected to be unveiled next year.
Fed Governor Sarah Bloom Raskin raised concerns about a section of the rule that allows the largest banks, those with more than $250 billion in assets, to use complex formulas to determine the risk of assets and consequently the capital needed to offset that risk.
She said banks have not always used these models wisely and that regulators will have to pay particular attention to the issue.
"Trust but verify," she said.
The effectiveness of these models, known as VaR, or value-at-risk, has been a source of debate in recent weeks because of the role they played in the JPMorgan's trading losses.
Also on Thursday, the Fed board voted 7-0 to approve a final rule implementing new capital standards regarding risks posed specifically by banks' trading books.
This update for trading books is known as Basel 2.5.
In response to the financial crisis, regulators across the world agreed to update their capital guidelines to better take into account the risks from such things as securities made up of mortgages, which played a key role in the meltdown.
U.S. regulators had delayed putting this rule into place because the 2010 Dodd-Frank financial oversight law prohibits regulators from allowing banks to continue to use ratings done by credit rating agencies to comply with U.S. banking regulations.
Regulators have struggled since the law was enacted to find an alternative to the work done by credit ratings agencies that banks can use when assessing the risk of assets for the purpose of complying with federal regulations.
In December, regulators proposed a set of alternatives but banks have argued that some of these substitutes will not be effective in measuring risk.
For instance, they have questioned whether relying on assessments done by the Organisation for Economic Co-operation and Development (OECD) to gauge the riskiness of sovereign debt will work.
In the proposed final rule released on Thursday the Fed rejected this concern and said regulators will use OECD ratings.