The August recess opened this week with two headline developments. Donald Trump was indicted Tuesday and arraigned yesterday, booked and fingerprinted before pleading not guilty to four counts of conspiring to remain in office after his defeat in the 2020 election. And the U.S. sovereign debt credit rating was cut by Fitch Ratings from AAA to AA+ for “repeated debt limit standoffs and last-minute resolutions.”
Last week, we saw a less-noticed but more salutary development, as the Fed, FDIC, and OCC proposed long-awaited rules to strengthen capital requirements for large banks. The long-overdue final phase of regulators’ push to implement “Basel III Endgame” — designed to increase resiliency in the banking sector and coming directly following the banking crises earlier this year — met with industry opposition, with JP Morgan CEO Jamie Dimon calling it “hugely disappointing.” We detail the proposal below.
Good weekends, all …
Dana
Last Thursday, the Federal Reserve, Federal Deposit Insurance Corporation (FDIC) and Office of the Comptroller of the Currency (OCC) released their long-awaited proposal to implement stricter capital requirements on banks with $100 billion in assets or more.
The proposal represents a significant step in the long journey to bringing the United States into compliance with Basel III requirements, and would increase common equity tier 1 capital requirements by an average of 16 percent across the largest banks. The plan comes as the banking sector has tentatively stabilized after facing turmoil earlier this year, giving stakeholders an opportunity to review and provide holistic feedback.
The proposal has the capacity to strengthen the financial system’s ability to withstand crises like the one seen following the collapse of SVB this spring. Already, however, it has faced pushback from some leaders at the Fed, including Governors Michelle Bowman and Christopher Waller, major figures at the FDIC, including Vice Chair Travis Hill and member of the FDIC Board of Directors Jonathan McKernan, and, of course, from the bank lobby.
What Would The Proposed Rule Change?
The Fed, FDIC, and OCC’s joint proposal would replace the existing risk-based capital framework for large banking firms with a new framework that would apply to banking firms with $100 billion or more in total assets and firms that engage in significant trading activities.
The proposed rule would implement the final components of the Basel III or “Basel Endgame” regulatory capital framework, the final set of reforms published by the Basel Committee on Banking Supervision in December 2017.
Regulators’ proposal would update U.S. capital standards to better reflect:
- Credit risk
- Trading risk
- Operational risk
- Derivative risk
The proposed rule would require banks to use a standardized risk-based measure of credit risk instead of their own internal estimates. Internal models have the potential to underestimate risk since they are prone to greater variability, making them harder to interpret, due to lack of consistency and comparability of the results. Proposed changes would improve the consistency of capital requirements across large firms and make it easier for supervisors and market participants to make independent assessments of a firm’s capital adequacy.
To address trading risk, the plan would adjust the way that banking firms are required to measure market risk – the risk of loss from changes in market prices. The proposed rule would correct for gaps in the current system. It would provide less credit for diversification across risk classes since the correlation between different classes and risk can change dramatically during times of stress. It would also require more capital for positions that are less liquid to better capture the difficulty of exiting these positions. Notably, under the proposed rule, the largest banks still opt for a standardized rather than a fundamental review of the trading book.
Operational risk refers to the losses a banking firm may face because of inadequate or failed processes, including losses due to fraud or cyberattacks. The proposed rule would replace the currently required internal model of operational risk, modeled by banks themselves, with a standardized measure that considers a firm’s activities in estimating its risk. Additionally, a firm’s operational risk charge would increase based on its historical operational losses under the proposal. This provision is designed to incentivize firms to mitigate their operational risk.
The plan also seeks to improve the capital treatment of derivatives by introducing a standardized risk-sensitive measure of valuation risk caused by changes in counterparty credit.
Specifically, the proposal would require banks with $100 billion in assets or more to:
- Include unrealized gains and losses from certain securities in their capital ratios
- Comply with the supplementary leverage ratio requirement
- Comply with the countercyclical capital buffer, if activated
Overall, the proposal would increase common equity tier 1 capital requirements by an average of 16 percent, with the largest and most complex banks being most affected. Most banks already have enough capital to meet the new requirements. The Fed estimates that banks that would need to build capital to meet the new requirements would be able to do so through retained earnings in under two years, assuming that they continue to earn money at the same rate they have in previous years and maintain their current level of dividends.
The new rules would be fully phased in over a three-year period beginning in 2025 and ending on July 1, 2028 under the current proposal.
Background and Importance
Capital is the vital buffer banks use to absorb potential future losses, and strong capital is foundational to a fair, safe, and resilient banking system. Regulators recognized this after the 2008 financial crisis. In the early 2010s, the Board of the Federal Reserve adopted an initial set of reforms to increase the quantity and quality of capital, run an annual supervisory stress test, and set a capital surcharge on global systemically important banks (G-SIBs) to reflect the greater threat their failures pose to financial stability.
These reforms had a clear and significant impact on financial resilience over the past decade. Since 2009, U.S. banking firms more than doubled their capital. The common equity capital ratio of the largest banks increased from 5.5 percent in 2009 to 12.4 percent at the end of 2022. The U.S. banking system has experienced strong growth over this period, growing from $12 to $23 trillion in assets.
The joint proposal represents the biggest stride towards ensuring further resilience since the financial reforms of the early 2010s. Recent turmoil in the banking sector makes it clear that attention must be paid to enhancing resilience right now. The proposed rule seeks to implement the lessons learned from this period of banking stress by directly addressing specific risks that were in play this spring. Importantly, it seeks to align capital requirements with actual risk so that banks bear the responsibility for their own risk-taking.
The Path Forward
The extensive plan represents a significant step towards strengthening the resilience of financial institutions and the broader financial system. It would reduce the chance of bank collapses and the need for bailouts by placing the burden on those taking the risks. Nonetheless, the plan has already received pushback.
Trump-appointed Federal Reserve Governors Michelle Bowman and Christopher Waller voted against the proposed new rules at the Fed Board of Governors’ open meeting last Thursday. Meanwhile, Federal Reserve Chair Jerome Powell – who voted in favor of the proposal and supported Barr’s effort – has expressed skepticism about potential costs of the plan.
FDIC Vice Chair Travis Hill and member of the FDIC Board of Directors Jonathan McKernan announced that they will not be supporting the proposed increase in capital requirements in separate statements published hours after the proposal was publicly released.
Federal Reserve Vice Chair of Supervision Michael Barr, who led the review of capital rules, claims that the increased ability of the financial system and financial institutions to weather a range of economic and market conditions outweighs any potential impact of increased requirements on lending activities and the cost to economic activity that may result.
The Fed intends to collect additional data to refine its estimates of the rule’s effects. A comment period in which the public can weigh in to flag potential implications of the proposal is underway. Public comments on the proposal are open until November 30, 2023. We hope that despite opposition from industry groups that stand to benefit from weaker requirements, a final rule will retain the strong reforms outlined in the proposal.