The Federal Reserve’s regulatory chief, in September 2024, outlined a sweeping overhaul easing two major draft bank capital rules following intense industry opposition that delayed the projects and sparked divisions among the top federal banking regulators.
Fed Vice Chair for Supervision Michael Barr said regulators would reissue watered-down drafts of the so-called “Basel Endgame” rule and a separate capital rule for global banks, in a major win for Wall Street lenders which have aggressively lobbied to weaken them.
The draft Basel rule, first unveiled in July 2023, overhauls how banks with more than $100 billion in assets calculate the amount of capital they must put aside to absorb potential losses. The other draft rule for global systemically important banks (GSIBs) aims to make capital levels for those lenders more risk-sensitive.
In July 2024, reports surfaced that the Federal Reserve was considering changes to a specific rule. Originally, the plan aimed to increase capital requirements for the largest American banks by approximately 19%. However, after a significant revision of the draft, that percentage has now been reduced to 9%, according to Barr.
He added that banks with under $250 billion in assets will be mostly exempt from Basel, which is good news for players like KeyBank, M&T, Huntington, and Fifth Third, among others.
Those lenders will only have to account for unrealised gains and losses on securities in their portfolio, an issue which sparked turmoil in the banking sector of the world’s largest economy in 2023. Overall, their capital increase would be roughly 3-4%, Barr added.
A sensitive topic
The recent policy changes may trigger another wave of industry lobbying, which could ultimately lead to further weakening of the rules.
While regulators say the rules will make the banking system safer, especially after three big American lenders failed in 2023, progressive groups and some Democrats may criticise the Fed for being too soft on the industry. In public campaigns and conversations with Washington lawmakers and regulators, Wall Street banks have argued against the infusion of more capital, saying the move will hurt the economy. They have been threatening to sue to kill the final rule on grounds the “US central bank and other agencies did not follow the proper procedure.”
Bowing to that pressure, Fed Chair Jerome Powell said this summer that regulators would make “broad and material” changes and that the new draft should be re-proposed for public feedback.
However, officials have been at loggerheads with their counterparts at the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC) who wanted to finalise the rule before the all-important 2024 Presidential Election.
The Fed’s decision to overhaul the GSIB surcharge plan is also a win for big banks, who have lobbied the central bank for years to update the rule to account for economic growth, which would in turn lower their capital burdens.
US Treasury Secretary Janet Yellen recently emphasised the importance of adjusting the complexity and severity of banking regulations based on the activities of institutions. This approach aims to prevent unnecessary compliance burdens. She also expressed her support for strong capital requirements.
Janet Yellen also credited the strong capital requirements put in place after the 2007-2009 financial crisis behind the US economy weathering the COVID-19 pandemic well. She also said the industry’s concerns that the 2010 Dodd-Frank banking regulation law would make US banks uncompetitive were proved unfounded, but has heard industry complaints about increasing regulatory burdens “loud and clear” and added that regulators should coordinate their approaches.
She went on to say that the Treasury and regulators would work with the banking sector to address vulnerabilities revealed by turmoil in 2023 after the failure of Silicon Valley Bank and Signature Bank. Some of these concerns are increased shares of uninsured and concentrated deposits and unrealised losses on loan and securities portfolios.
Why is the banking sector up in arms?
The industry has launched an aggressive campaign against a reform in capital rules. The reform has been named ‘Basel III endgame’ after the Swiss city where the Bank for International Settlements (BIS) that oversees central banks is based. When the reform proposals came in the first half of 2024, it required banks with over $100 billion in assets to set aside tens of billions more by early 2028.
The proposals also talked about these banks having to include a larger part of losses in capital ratios, which would in turn have resulted in these institutions no longer being able to use lower historical capital losses to reduce their capital requirements. The reforms were drawn up to reduce “systemic risk and improve the US banking sector’s resilience.”
The overhaul aimed to harmonise US capital rules with international standards. Most developed economies have already implemented capital rules dictated by the Basel Committee on Banking Supervision, which sets global capital requirements. In 2017, the committee reached an agreement for higher capital requirements to address concerns that ‘Basel III,’ a banking regulation package implemented after the credit crunch, had failed to tackle systemic risks.
Basically, the “Basel Accords” are a series of three sequential banking regulation agreements (Basel I, II, and III) set by the Basel Committee on Bank Supervision (BCBS). The committee provides recommendations on banking and financial regulations, specifically, concerning capital risk, market risk, and operational risk. The accords ensure that financial institutions have enough capital on account to absorb unexpected losses.
In the wake of the Lehman Brothers collapse of 2008 and the ensuing financial crisis, the BCBS decided to update and strengthen the Accords. The BCBS considered poor governance and risk management, inappropriate incentive structures, and an overleveraged banking industry as reasons for the collapse. In November 2010, an agreement was reached regarding the overall design of the capital and liquidity reform package.
This agreement is now known as Basel III. It now requires banks to have a minimum amount of common equity and a minimum liquidity ratio. It also includes additional requirements for what the Accord calls “systemically important banks,” or those financial institutions that are considered “too big to fail.” In doing so, it got rid of tier three capital considerations.
The Basel III reforms have now been integrated into the consolidated “Basel Framework,” which comprises all of the current and forthcoming standards of the Basel Committee on Banking Supervision. Basel III tier one has now been implemented and all but one of the 27 Committee member countries participated in the Basel III monitoring exercise held in June 2021.
The 2023 collapse of Silicon Valley Bank raised eyebrows about the practices of smaller banks. Just a few months later, First Republic, a San Francisco-based bank, followed suit. Crucially, the proposed rules were also supposed to cover regional lenders previously exempt from strict capital requirements.
Under the initial proposals, banks were required to increase their capital when regulators anticipated a recession, as the regulators aimed to prevent further bank bailouts.
“Since the real estate market and debt scenarios have started to mimic the pre-2008 crash scenarios, regulatory organisations are trying to prevent a banking sector collapse with strict policies,” said Ethan Keller, president of Dominion, a US-based network of legal and financial advisors, while interacting with the World Finance.
Concerns and pushback
The proposals sent a shockwave across Wall Street. An analysis by the law firm Latham & Watkins found that a staggering 97% of responding institutions to the public consultation process found the changes problematic. Banks fear that stricter capital requirements will limit their lending capabilities, hurting the US economy and especially SMEs.
Their bone of contention was the risk-weighted assets (RWA), which are measured based on a risk weighting assigned to banks’ operations. As the denominator to determine capital ratios against future losses, low RWAs help banks look stronger financially. Previously, banks were allowed to use their own models to gauge risk, but discrepancies in modelling across the industry have urged regulators to set a common standard to measure operational risk.
Critics, as soon as the initial draft reforms came out, argued that the proposals, if realised, would increase capital requirements for mortgages and corporate loans, and even put products such as the hedging contracts airlines use for fuel purchases in jeopardy.
“The pushback is justified, because the rules will have costs but no clear benefit,” said Charles Calomiris, an expert on financial institutions teaching at the University of Austin, while interacting with World Finance. Other experts, however, question the validity of the banks’ claims.
“If the loans are good loans to make in the first place, why wouldn’t they be willing to fund them with a portion of money from their shareholders. The kind of loans that capital requirements are going to lead to a reduction in are loans that were bad loans to start with – that is, loans that only make sense to the bank if it can get the profits if the loans perform well, but pass off the costs if they perform badly,” said Michael Ohlrogge, an expert on financial regulation teaching at NYU School of Law.
Critics of banks also argued that their real concern was pay, as higher equity capital will hit executive bonuses based on return-on-equity, and possibly dividends and share buybacks.
Regulators estimate that the new rules will lead to an aggregate 16% increase in capital requirements for the largest banks. However, they clarified in their initial proposal that “the largest US bank holding companies annually earned an average of 180 basis points of capital ratio between 2015–2022,” meaning that the hit would be mild at best.
The 12 largest banks in the United States currently hold a record $180 billion in excess common equity tier one capital, which is a key indicator of their financial strength. However, several banks and lobbying groups have expressed concerns regarding these projections. The Bank Policy Institute, representing large and mid-sized banks, estimates that the largest banks may need to increase their capital by up to 24%. Some banks argue that they are already financially robust and worry that raising capital requirements could lead to higher costs without necessarily enhancing safety. Additionally, the Financial Services Forum (FSF), which represents the eight largest US banks, estimates that its members had $940 billion in capital in 2023, which is three times the amount they had in 2009.
Another concern was the potential loss of international competitiveness, as American banks were required to comply with more stringent capital requirements than those their competitors face, currently standing at 3.2% for large British banks and 9.9% for European Union-based ones. Diminished internal competition could be another unintended consequence if more banks merge to comply with the new rules. One of the regulators, the Federal Deposit Insurance Corporation (FDIC), recently proposed reforms that would make big bank mergers more difficult.
“Considering EU banks’ existing technology and framework to maintain the Basel framework, this will give them a competitive advantage over US banks. As this framework means additional costs for training, tracking, and setting aside a specific portion of the capital, the banks will churn out the additional costs from the customers. Hence, smaller banks with Basel Endgame exception will gain a new clientele not willing to pay extra money for US banking conglomerates,” said Ethan Keller, president of Dominion, a US-based network of legal and financial advisors, at a time when the first set of policy recommendations came from the American regulators.
As the pushback intensified, Fed watered down the most stringent rules of the initial proposal and acknowledged that a balance had to be struck between potential costs and the stability of the financial system. Fed board members like Michelle Bowman and Christopher Waller also raised concerns over reduced competition, curtailed lending, less liquidity and costlier credit as a result of the changes.
Basel Rules became poll issue too
As the United States voted for its next President in 2024, “Basel Rules” became a political issue as well. The banking industry launched a website where voters could notify elected representatives about their concerns. Banks also lobbied lawmakers to put pressure on regulators. Many Republican Congressmen and senators openly opposed the reforms.
When the initial proposals were announced, regulators were concerned about the 2023 bank failures, while Joe Biden administration officials were worried about an imminent financial crisis.
Stricter capital requirements may be implemented globally, especially in light of recent changes to US regulations and potential overhauls of Basel regulations. This comes at a time when banks and regulators around the world have taken notice of these developments. Ironically, the Swiss government, home to the BIS, has proposed increasing capital requirements for Swiss banks following the collapse of Credit Suisse in March 2023.