With the flurry of activity around increased financial regulatory oversight and the need to ensure a healthy financial system, banks find themselves in the position of reviewing existing procedures regarding capital reserves. In July 2023 the Federal Reserve, the FDIC, and the Office of the Comptroller of the Currency (OCC) issued a proposal aimed to enhance the resilience of banks and the stability of the financial system by ensuring that banks hold sufficient capital to cover risks. The primary goals are to improve the quality and quantity of bank capital, enhance risk coverage, and introduce leverage and liquidity requirements.
Michael S. Barr, Vice Chair for Supervision at the Federal Reserve Board, delivered a speech on September 10, 2024 at the Brookings Institution in Washington, D.C. During this appearance, he discussed the importance of bank capital and the balance between resiliency and efficiency in the financial system. He offered several updates and re-proposals he hopes to put in front of the Federal Reserve Board for consideration on the Basel III endgame.
What Is Being Re-Proposed for Basel III Endgame?
Mr. Barr recommends that the Board re-propose Basel III endgame, which will provide the opportunity to fully review several key broad and material changes to the original proposal. According to his speech, the changes in the endgame re-proposal will cover all major areas of the rule (credit risk, equity exposures, operational risk, and market risk). Another significant change proposed is that “banks with assets between $100 and $250 billion would no longer be subject to the [Basel III endgame rules], other than the requirement to recognize unrealized gains and losses of their securities in regulatory capital.”
Credit Risk
- Lowering Risk-Weighting: Proposed reduction in risk-weighting for loans secured by residential real estate and loans to retail customers
- Loans secured by residential real estate: reduce the “calibration” for residential real estate exposures so that it is in line with the calibration developed in the Basel process. With this change, all-in capital requirements will be lower on average than they are currently for mortgages up to 90% loan-to-value ratio, and about the same as they are now for mortgages up to 100% loan-to-value.
- Loans to retail customers: Lower the credit card exposures where the borrower uses only a small portion of the commitment line and lower the capital requirements for charge cards with no pre-set credit limits
- Extending Reduced Risk Weight for Low-Risk Corporate Exposures: Inclusion of certain regulated entities that the bank judges to be investment-grade but not publicly traded, e.g., pension funds, certain mutual funds, and foreign equivalents.
- Eliminating Minimum Haircut From the Original Proposal: A recommendation not to adopt the minimum haircut requirements for securities financing transactions to seek greater international consensus.
Equity Exposures
Significantly lower the risk weight for tax credit equity funding structures due to lower inherent risk in these structures compared to other equity investments.
Operational Risk
- Eliminating adjustments to a firm’s operational risk charge based on its loss history to reduce fluctuations over time.
- Measuring fee-based activities based on net income rather than gross revenues, which would produce more consistency on how operational risk is measured across bank activities. This approach is “less sensitive to the differences in accounting practices across banks.”
- Lowering requirements for investment management activities due to historically lower operational losses.
Market Risk
- Facilitating Use of Internal Models: Introducing a “multiyear implementation period” for profit and loss attribution tests to improve model performance.”
- Mortgage-Backed Securities: Clarifying that like mortgage-backed securities positions “would be treated as having a single obligor, regardless of whether they were issued by Freddie Mac or Fannie Mae.”
- Derivatives: Reducing capital required for client-facing leg of client-cleared derivatives to reflect risks associated with these transactions.
Are Financial Institutions Ready to Bank on Basel?
In addition to these proposed changes regarding credit, equity exposures, and market and operational risk, a suggested framework of “tiering” will apply the most stringent requirements to global systemically important banks (G-SIBs) and internationally active banks, while a simplified capital framework for large banks that are not G-SIBs should be created, with certain exceptions.
According to the speech:
- For firms with assets between $250 and $700 billion that are not G-SIBs or internationally active: The re-proposal would apply the new credit risk and operational risk requirements; however, it would only apply the frameworks for market risk and credit valuation adjustment (CVA) frameworks to firms that engage in significant trading activity.
- For firms with assets between $100 and $250 billion: The re-proposal would not apply the credit risk and operational risk frameworks of the expanded risk-based approach to these organizations. Therefore, as noted previously, these firms would no longer be subject to the Basel III endgame rules, other than the requirement to recognize unrealized gains and losses of their securities in regulatory capital.
- For all firms with assets between $100 and $700 billion: The re-proposal would revert to the simpler definition of capital—the numerator in the capital ratio—for these firms that is currently in place, with the exception of applying the requirement to reflect unrealized losses and gains on certain securities and other aspects of accumulated other comprehensive income (AOCI). The re-proposal would maintain this component to better reflect interest rate risk in capital, an issue that played a major role in last year’s bank failures.
G-SIB Surcharge Re-Proposal
In addition to the proposed updates discussed previously, Barr also recommended updates to the proposed G-SIB surcharge as part of the framework. Additional adjustments impacting G-SIBs include:
- Not adopting the proposed changes to capital requirements associated with client clearing (to avoid disincentives for central clearing of derivatives)
- Improving the calculation of the capital surcharges “by reflecting changes in the global banking system since the Board adopted the G-SIB surcharge in 2015.” The growth in the economy since 2015 has meant that G-SIBs’ measures of systemic risk have increased, even for firms whose share of domestic or global economic activity has not increased.
- Accounting for effects from inflation and economic growth in the measurement of a G-SIB’s systemic risk profile, not changing it based simply on growth in the economy.
Bracing for Basel III Endgame’s Impact on Banks
Understanding the proposed changes to Basel III endgame will be of paramount importance for impacted G-SIBs and larger banks. However, in navigating these changes, it is worthwhile to note the key distinctions between the classifications:
Potential Impact on Large Banks (G-SIBs)
- Aggregate common equity tier 1 capital requirements for G-SIBs estimated to increase by 9%
- Enhanced resilience of the largest and most complex banks, reducing systemic risk
Potential Impact on Non-G-SIB Large Banks
- Requirement to recognize unrealized gains and losses on securities in regulatory capital
- Equivalent to an estimate of 3 to 4% increase in capital requirements over the long run
- The remainder of the re-proposal would increase capital requirements for non-G-SIB firms still subject to the rule but estimated at 0.5%
It is worth pointing out that the operational and strategic considerations involved may mandate that banks will need to adjust their business models and risk management practices. Financial institutions should anticipate seeing potential increases in costs due to higher capital requirements and adjustments to operational risk management.
The broader economic and market implications of these proposed recommendations to Basel III endgame go beyond ensuring adequate capital reserves are in place for G-SIBs and larger banks. Any possible cost/benefit to these proposed changes may result in impacts that will reverberate throughout the financial system, affecting the availability and cost of credit for households and businesses. It remains in the collective best interest to help ensure that the financial system remains resilient while supporting economic growth.
If you have questions or would like more information, please reach out to a professional at Forvis Mazars.
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