The FRB has finalized tough new rules on mortgage-originator compensation and related practices even as new law mandates still tougher requirements going forward. The FRB’s regulations prohibit yield-spread premiums (YSPs) and similar forms of originator compensation. “Steering” is also banned, although a safe harbor is provided if consumers are presented acceptable product options. The rules cover all loan originators as defined, not just independent mortgage brokers. As a result, all mortgage originators, including banking organizations, may need to change compensation and mortgage-marketing practices, doing so on a rapid turn-around even as broader rules advance. The sum total of all of these rules may well be a strategic redefinition of U.S. mortgage finance that, while it promotes consumer protection, also leads to greater concentration of origination in the largest banking organizations.

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Treasury’s Office of Foreign Asset Control (OFAC) has issued final rules to implement provisions of the Comprehensive Iran Sanctions Accountability and Divestment Act.  The Iranian Financial Sanctions Regulations (IFSR) are intended to isolate sanctioned Iranian government programs from financial institutions and to penalize any institutions that provide financial services to them.  If Treasury finds that a foreign financial institution (FFI) has knowingly engaged in a prohibited activity, Treasury may restrict or prohibit the FFI and domestic financial institutions (DFIs) from opening or maintaining a correspondent account or payable-through account for the sanctioned FFI in the U.S.  Additionally, DFIs and the entities they control are prohibited from transactions benefiting Iran’s Revolutionary Guard.  Violations of the new law are punishable as violations of the Bank Secrecy Act and International Emergency Economic Powers Act, resulting in significant legal and reputational risk in this high-profile arena and increasing the importance of thorough due diligence in correspondent account relationships.

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As markets held their breath, Chairman Bernanke’s speech today in Jackson Hole took on the semblance of a sermon on the mount. It was, of course, far less than that, with the Chairman keeping to the careful phrasing that always characterizes central bankers. But, Mr. Bernanke’s tempered tone was due not just to inbred central-banker discretion – it also results from deep weaknesses in the U.S. banking system which sharply limit the Fed’s quantitative-easing options. The Fed simply can’t pay less for all the funds it holds because all banks could do with them is put them into still more government bonds – scant capital reserves give banks little leeway to start lending again. And, were Mr. Bernanke to say so, markets would resume their frightening, volatile ways.

In the list of “unconventional” monetary-policy options assessed today by Mr. Bernanke lies one with far-reaching impact on bank capital and profit projections: reducing the interest on excess reserves (IOER). In our view, it’s these reasons – far more than the monetary-policy ones cited in the speech – that will keep the Fed’s hands off IOER for the foreseeable future. As long as IOER earns more than Treasuries, banks will keep their funds locked up at the central bank or put them in government bonds because scant capital reserves give them little choice. This is the sorry fruit of the procyclicality that characterized regulatory-capital rules, and the Fed now can do little about it but confer with other central bankers about counter-cyclical capital rules to come.

The reason for the big impact on banks – especially large ones – is clear from the scope of reserves now housed at the Fed: $1.02 trillion. The Fed is paying a relatively meager return on these funds – 25 basis points (bps) – although this still beats the zero paid on Fed funds. Mr. Bernanke suggested that the central bank could drop IOER to 10 bps or even to zero to spur banks to move money into the private capital markets, but noted several monetary-policy reasons why this might do little to spur credit availability and, with it, economic growth. However, these concerns are not the only ones staying the Fed’s hand. They are all Mr. Bernanke cited, but he could say no more without rattling markets.

Despite the capital rebuild at most banks in recent months, banks are far from robust, especially given the drawdown of reserves that characterized second-quarter earnings in the face of steady loan losses and volatile financial markets. It’s no surprise that, as these trends continue, funds held at the Fed have reached unusually high levels. Funds held at the Fed earn a zero risk weighting – meaning that banks can arbitrage the heck out of the Fed – taking earnings from excess reserves and plowing them into Treasury securities – with no adverse impact on regulatory capital. This rebuilds balance sheets and strengthens banking, but at no benefit to non-government borrowers. Mr. Bernanke said today that dropping IOER wouldn’t do the macro economy much good because banks would principally put the money into Treasury holdings. He didn’t say why, but we think it’s the capital issue: taking money out of Fed reserves and putting it to work in the market means taking zero-weighted assets and putting them into loans or similar holdings with far higher risk weightings now and still more costly ones to come under Basel III.

Simply put, taking money out of the Fed and giving it to the small businesses touted in Mr. Bernanke’s speech means holding 100 times more capital – loans without a government guarantee have a 100 percent risk weighting, not the zero granted the Fed. “Prudent” mortgages would cost fifty times more capital. Putting the money into agency or GSE holdings still packs a punch, as they carry a twenty percent weighting. Loans have to earn a lot and at the same time satisfy spooked supervisors to traverse this capital abyss.

Treasuries are just too darn comfy under current market conditions – and the Fed knows this full well. Had capital been less procyclical before the crisis, banks would have had reserves earning IOER that could be deployed to advance the Fed’s exit strategy. With no capital to spare, banks are keeping what they’ve got right where it is, making the way out of the Fed’s quantitative easing all the harder.