Big banks fret over capital disparities between U.S., U.K. Basel proposals

Bloomberg News

Already concerned about the impact of proposed capital reforms at home, large U.S. banks now worry that less stringent policies taking shape abroad will make them less competitive on the global stage.

This week, the Bank of England — the UK equivalent to the Federal Reserve — rolled out a “near final” version of its Basel III implementation. The reforms would increase capital obligations on U.K. banks by 3.2%, well below the cumulative increase of 16% called for by the proposal put forth by American regulators. 

The Financial Services Forum, an industry association representing the largest U.S. banks, said the disparity between the two proposals will exacerbate the competitive disadvantage American banks already face relative to their peers in England and elsewhere in Europe.

Sean Campbell, the FSF’s chief economist, said the disparities between the two approaches undermines the credibility of the standards put forth by U.S. bank regulators and the Basel Committee on Bank Supervision as a whole.

“There needs to be consistent regulation across jurisdictions to ensure that one government or another is not subsidizing one set of banks. That’s the underlying premise of the Basel Committee, but in practice, it hasn’t worked out that way,” Campbell said. “Across the pond, things get implemented in a manner which is significantly less stringent than here in the U.S., so this disparity has built up over the last 20 years. And here we see, yet again, that disparity is just going to grow.”

Supporters of the proposed reforms, meanwhile, note that higher capital requirements in the U.S. have not stopped American banks from outperforming their global peers in the past.

Jeremy Kress, a business law professor at the University of Michigan and a former Fed lawyer, said similar complaints about the “gold-plating” of U.S. regulations relative to international standards arose after the implementation of the Dodd-Frank Act in 2010 and the initial iteration of Basel III in 2013. Yet, since then, U.S. banks have seen higher stock prices, wider net interest margins and better returns on assets than banks in the U.K. and continental Europe.

“U.S. banks’ strong performance relative to European competitors makes sense, since capital makes our financial system strong. The real risk to international competitiveness is lax prudential regulation,” Kress said. “In fact, the trend of U.S. banks outperforming European banks reversed in 2023, when the U.S. experienced a banking crisis due, in part, to lax regulation.”

Much like the so-called Basel III endgame proposal put forth by the Fed, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency in July, the Bank of England’s “Basel 3.1” framework brings the country into alignment with the standards put forth by the Basel Committee in 2017.

The standards are the final component of the international regulatory response to the subprime mortgage crisis and global financial distress that ensued. They establish uniform methods for measuring credit, market and operational risks and assigning capital holdings to them. But the framework also grants “national discretion,” allowing individual jurisdictions to opt out of certain components or add onto them as they see fit.

The Bank of England has used this discretion in how it treats operational risks, such as those related to litigation, cybercrime, fraud and malpractice by bank employees. Instead of using banks’ past operational losses to create a multiplier for operational risk capital requirements, the U.K. regulator has set its internal multiplier at one, thus eliminating the “mechanical link” between past losses and future capital requirements.

“The [Prudential Regulatory Authority] acknowledges that historical losses can provide some important information when considering operational risk,” the proposal reads. “However … the PRA considers that a mechanical link to past losses is inappropriate for a number of reasons, including that the ‘fat-tailed’ nature of operational risk losses – being infrequent but very large – means past events (particularly over a lengthy historical period) are generally not good predictors of future losses.”

The U.S. proposal, meanwhile, asserts that not only are historical operational losses associated with future risk exposures, but also that deficiencies in managing these risks can be “persistent.” Because of this, it uses average annual operational losses to amplify the operational risk capital requirements and has a minimum multiplier of one.

Mayra Rodríguez Valladares, managing principal of the financial regulatory consulting firm MRV Associates, said accounting for operational risk is always “imperfect,” because it largely reflects human and environmental risks, which are harder to quantify than market and credit risks. 

“It’s unfortunately always going to be a moving target,” Rodriguez Valladares said. “Operational risk is really why banks fail. It’s always about people, the people who run them, and how they react to scandals or disasters. And those are things that are hard to see in advance.”

David Zaring, a law professor at the University of Pennsylvania’s Wharton School of Business, said the U.S. has the right to make its capital rules more stringent than the minimum standards set by the Basel Committee. But, he noted, doing so does undercut the goal of global uniformity. 

“One of the most impressive achievements of the Basel process has been the way it harmonized capital requirements across jurisdictions without the need for a binding treaty,” Zaring said. “When American banking regulators opted to layer on capital requirements beyond those required by Basel III, they did take a chance that foreign regulators would not copy them. It loses some of the level playing field that fueled support for Basel.”

In this week’s policy statement, the Bank of England finalized several chapters of its proposed rule, incorporating public commentary on those specific provisions. It intends to issue a second near-final rule addressing the other elements of the framework in the second quarter of next year. The central bank noted that it does not intend to change any part of the framework finalized this week.

This process differs from the U.S. notice and comment rulemaking, in which there is one proposed rule, one comment period and then final rule put to a vote within the relevant agencies. Though, if substantial changes are made to the initial proposal, U.S. regulators must propose the rule again and hold another comment period. 

Another meaningful difference in the U.S. and U.K. approaches to capital reform, is the focus on competition. In its near final rule, the Bank of England noted that it considered “relevant international standards, international competitiveness, and the relative standing of the U.K. as a place for internationally active firms to operate.” 

Kress noted that the Bank of England only recently reinstated its mandate to protect the international competitiveness of its banks after removing it in the wake of the global financial crisis.

“In the United States, regulators have no such mandate,” he said. “Instead, Congress wisely instructed U.S. regulators to protect the safety and soundness of the domestic banking system. And for good reason: calibrating regulations based on international competitiveness has not worked out well in the past, such as in the U.K. prior to the 2008 financial crisis.”

The Bank of England declined to comment for this article. 

Campbell said U.S. regulators would do well to consider how their standards impact the ability of American banks to compete internationally, arguing that just because they can perform better in the face of stiffer regulatory requirements doesn’t mean they should have to.

“The notion that banks are effectively operating with one hand tied behind their back and they’re still doing well, doesn’t tell you that it’s a good idea to be operating with one hand tied behind your back. That’s an illogical argument,” he said. “The question is how well would they be doing if they weren’t being hamstrung by regulation that is being applied only to U.S. firms and not European ones?”