August 3, 2023 | Mark Taylor
Estimated reading time: 6 minutes
US regulators announce ‘Basel III endgame’
Tougher capital requirements that aim to improve the stability of big banks, billed the ‘Basel III endgame’, are to be rolled out by US regulators.
Whilst the rules will apply to all lenders with more than $100bn in assets, smaller banks may need to comply with the demand for higher capital buffers if they have significant trading activity.
The Federal Deposit Insurance Corporation (FDIC), which oversees stability and public confidence in the US financial system, the US Federal Reserve and the Office of the Comptroller of the Currency jointly announced the plan on July 27.
The regulators said banks will have until the beginning of 2028, nearly four and a half years, to comply with the new rules.
Why are banks unhappy with the Basel III endgame proposals?
Although trailed for several months and in the works for years, the recent announcement advances regulatory intentions to overhaul the way big banks manage capital, with implications for lending and trading.
“These changes are expected to significantly increase banks’ capital requirements over and above their historically high levels,” said Dr. Guowei Zhang, Managing Director, and Head of Capital Policy at SIFMA.
While higher capital levels have benefits like reducing the likelihood of a bank failure, Zhang said the increased costs could limit banks’ ability to support capital markets and the broader economy, making it harder and more expensive for businesses, consumers, and investors to obtain financing.
The immediate reaction from the industry was negative, with some firms stating it would hurt the economy.
“Basel III finalization and implementation is a top priority for the FDIC and all of the federal banking agencies,” said FDIC Chairman, Martin J. Gruenberg. “It offers us the opportunity to make important modifications to the risk-based regulatory capital framework with the ultimate goal of enhancing the financial resilience and stability of the banking system, better enabling it to serve the US economy.”
Responding to sector concerns, he said the measures would be phased in over several years, and not felt immediately, while the intention is to improve how banks operate during difficult periods.
“History has proven that insufficient capital can lead to harmful economic results when banks are unable to provide financial services to households and businesses, as occurred during the 2008 financial crisis,” he said. “Ensuring adequate amounts of bank capital provides a long-term benefit to the economy by enabling banks to play a counter-cyclical role during an economic downturn rather than a pro-cyclical one.”
A brief history of Basel III
The Basel III standard was introduced following the 2008 global financial crisis by international regulators, overseen by the Bank for International Settlements (BIS) in Basel, Switzerland.
Known as the ‘central bank of central banks’ the BIS has a mandate to ensure regulators globally apply similar capital requirements to ensure lenders can withstand loan losses during market shocks.
Regulators in each continent have worked since 2008 to implement the standards, and the so-called ‘endgame’ is the final set of measures for banks to comply with.
It is expected to tweak the Basel III approach to setting capital based on a bank’s risk appetite, and the US regime will mean changes to derivatives, credit, market, and operational risks.
The ability of banks to use their own internal risk models when deciding how much capital should be held against lending activities like corporate loans or mortgages is likely to be ended.
Federal Reserve Vice Chair for Supervision Michael Barr said banks are incentivized to keep their capital costs low, meaning internal models often deliberately underestimate risk. A uniform modeling standard is expected to be introduced.
Market risk updates
Regulators believe trading risks are on the rise, and banks are not taking enough precautions. As a result, the Basel III endgame is likely to bring in new rules around how banks measure risks posed by market fluctuations and potential trading losses.
Internal models will be permitted, but regulators will insist on standardized models for complex risks, and banks will have to model trading risks at the level of the desk involved, in a break from previous standards. It is likely to result in higher capital requirements for banks with significant reading operations.
New operational risk requirements
Operational risk demands are a new area introduced by the Basel III endgame proposals, following concerns that fallout from unexpected events could lead to heavy losses. This includes internal policy failures, management errors, regulatory fines and sanctions, litigation, cyberattacks or other external events like pandemics and adverse weather, and more.
Regulators want to replace existing internal models with a universal approach to capital-level calculations that would cover all the bank’s activities and its historical operational losses.
Lenders have warned this could result in significantly higher costs for some firms that earn large sums from non-interest fee income, like credit card rates and investment banking fees. Instead, these fees would be wrapped into a formula used to calculate operational risk, which some feel will result in disproportionately higher capital requirements if not capped.
Industry concern at new capital demands
The rules have been planned for several years; however, bank lobbyists had pushed hard for capital relief and feel the raises are unnecessary.
The industry believes it is well-capitalized, having ridden out the Covid-19 pandemic and emerged with strong balance sheets that routinely pass Fed stress testing.
The board of governors at the Fed are discussing the proposals, which with chair Jay Powell affirming in his opening remarks his support of the changes but acknowledging that a “balance” needed to be struck between safeguarding the banking system and the costs associated with demanding higher capital requirements.
“Regulators and other policymakers should carefully consider the harmful economic impact of this proposal,” said Kevin Fromer, of the Financial Services Forum, a lobbying group for the largest US banks.
He said the new rules could damage the US’s ability to compete with other economies, driving up the cost of loans and other services in comparison to Europe and the rest of the world.
A former top regulator at the Fed, Randal Quarles, previously estimated that full implementation of the Basel Accord could mean large banks need to hold up to 20% more in reserve.
It has also been argued that most banks already have enough buffers to meet the requirements, and those that need to raise funds could do so without too much trouble.
Current regulators, all appointed by President Joe Biden, have shown no incentive to give a pass to Wall Street, and point to the collapse of three lenders earlier this year, Signature Bank, Silicon Valley Bank, and First Republic Bank, as evidence the new rules are needed.
US implementation of the Basel III endgame reforms, in whatever shape the final rules take place, will have a significant impact on the global financial market. How banks structure their businesses and balance sheets will be entirely reconfigured to meet the new capital requirements, with no area of operation inside a lending or trading firm unaffected.
Widely expected for several years, managing the implementation will not be easy, as firms must contend with negotiating greater regulatory expectations whilst trying to fulfill their usual activities of lending, trading, facilitating payments and market making.
With the endgame in sight, banks can position themselves to ensure compliance with the final set of demands by partnering with CUBE to make sense of the regulatory obligations and automatically map them to your business profile.