recent developments and cross-border perspectives, David Sewell, Mac Mackenzie, Janina Heinz, Matthew O’Callaghan, Christopher Bernard

Following the failure of Silicon Valley Bank (SVB) and several other U.S. small and mid-sized banks in March 2023, U.S. regulators have proposed new capital and liquidity rules, as well as resolution planning  guidance, that will increase the compliance costs  for regional banks and could potentially lead to a new wave of consolidation in the U.S. banking industry and create opportunities for non-bank financial institutions and private capital providers. These proposals include plans to implement the final Basel III standards (often referred to as ‘Basel 3.1’), which are due to be rolled out across the world over the next several years, albeit with different timetables and some differences in approach depending on the jurisdiction, which could present implementation challenges for global banks. 

On 16 October 2023, a panel of senior Freshfields lawyers participated in a live webinar to discuss these and other recent developments related to regulatory capital, liquidity and resolution planning for banks. David Sewell, a partner from Freshfields’ New York office, provided an overview of the U.S. developments and regulatory proposals, after which Mac Mackenzie from the London office, Janina Heinz from Frankfurt and Matthew O’Callaghan, managing partner of the Hong Kong office, contributed the perspectives of practitioners in other international jurisdictions as well as insights into how the Basel 3.1 standards are due to be implemented in their respective regions.

The following blog post provides a summary of this discussion. For more information, a recording of the webinar is available here.

U.S. developments: more stringent requirements on the way

To date, 2023 has been one of the most consequential years for U.S. federal banking agencies since the global financial crisis of 2007-08. Plans to implement Basel 3.1 in the United States have long been in the pipeline, but the final proposals that were issued in August 2023, along with new requirements and guidance for resolution plans, were delayed—and influenced—by the banking turmoil that occurred in the spring. The proposals included new long-term debt (LTD) requirements that also were years in the making but positioned as a response to the regional bank failures. For more information about the proposals on LTD and resolution planning, see our earlier blog post.

These proposals are controversial and have generated an extraordinary amount of discord among policy makers, and even dissenting statements by some members of the Board of Governors of the Federal Reserve System, which is highly unusual and perhaps reflective of the partisanship that characterises the political landscape in the United States currently. 

What does this mean for U.S. banks? The direction of travel is towards more stringent capital, liquidity,  stress testing, and resolution planning requirements. Incentive compensation may come under increased scrutiny, and there is a call for greater risk management expertise on boards. Banks should expect more supervisory focus on concentration risk, and changes to the deposit insurance regime have also been floated. 

Perhaps most significantly, under the proposals, regulatory capital requirements and LTD obligations would increase for banks and holding companies of all sizes—not only those directly impacted by the market disruptions of earlier this year. Regional banks stand to lose the comparatively favourable treatment they enjoy under the current tailoring framework and would have to comply with more stringent capital and liquidity rules. This could lead to an uptick in M&A activity and price banks out of some markets such as residential mortgages, creating new opportunities for hedge funds and private capital providers.     

The UK perspective: a new regime for smaller banks

In some respects, the recent U.S. proposals appear to bring the United States more into line with the UK and EU, for example with regard to LTD requirements. Now that the UK is no longer part of the EU, however, its prudential regime is starting to diverge, as demonstrated by differences in its plans to implement Basel 3.1 as compared with the EU’s proposals. Banking groups that operate in both jurisdictions may therefore be faced with a choice of complying with two separate systems or applying the higher set of standards throughout.

One area of divergence from the United States and the EU is the application of regulatory capital rules to smaller banks. While the United States is shifting closer to the EU in this regard, the UK is actually moving in the opposite direction with the planned introduction of a new ‘strong and simple’ framework for small domestic banks and building societies. Differences between the UK and EU are also emerging with regard to bank remuneration: the Financial Conduct Authority (FCA) and Prudential Regulation Authority (PRA) recently confirmed that they are removing the bonus cap that the UK inherited from the EU. Changes are also proposed to the UK’s bank ring-fencing regime, though that regime has never had an equivalent in the United States or the EU.

Another area of divergence is the approach to the internal models used by banks. Whereas in the United States, the regulatory agencies are signalling a move away from models, that is not the case in the UK, though a set of new model risk management principles for UK banks have been adopted by the PRA and will come into force in May 2024. 

Implementation of the Basel 3.1 reforms was due to start in the UK by January 2025, the same time as the EU. However, that has now been delayed until July 2025, bringing the UK timetable into line with the United States. The standards will be introduced over a long transitional period stretching to 2030 in the UK, compared to full compliance by July 2028 in the United States under current proposals.

The EU perspective: Basel 3.1 plus

In the EU, Basel 3.1 will be implemented through amendments to the Capital Requirements Regulation (CRR) together with amendments to the Capital Requirements Directive (CRD). These amendments, known as CRR III and CRD VI, were included in a legislative package proposed by the European Commission in 2021, and the European Parliament and Council reached provisional agreement on the final text of this legislation in June 2023. While the main focus of the amendments is the implementation of Basel 3.1, including the output floor and other revisions to the internal models approach, the EU is also introducing a number of other changes that set it apart from other jurisdictions.

First, the legislative package provides for further harmonisation of prudential regulation within the EU. In particular, the ‘fit and proper’ process for testing the suitability of banks’ board members will be made more consistent across Member States, as will the powers of competent authorities to assess bank mergers and acquisitions. CRD VI will also harmonise the requirements for third-country firms seeking to access EU markets, which are currently largely a matter of Member State law. Going forward, third-country firms seeking to access the EU will need to do so via a branch, subject to certain exemptions and grandfathering rules.

In addition, new pan-EU requirements for managing environmental, social and governance (ESG) risks will be formally introduced and will likely be an ongoing focus for the European Central Bank (ECB), which supervises the biggest EU banks by virtue of the Single Supervisory Mechanism (SSM). The legislative package does not go as far as introducing green supporting factors or brown penalties for capital requirements, but the discussions around ESG are still evolving, so that may change.

Other things to look for in the future in the EU include the prudential treatment of cryptoassets, which is only touched upon lightly in the current legislative package, and the regulation of shadow banking. Another trend is the increasing willingness of EU and national authorities to use the full supervisory toolkit available to them: relying on not just quantitative measures but also qualitative measures such as requiring institutions to change their governance arrangements, as well as applying other enforcement measures such as risk reduction measures for certain businesses, periodic penalty payments in cases of deficiencies that aren’t properly dealt with by banks, and pecuniary sanctions for breaches of the framework.

The Asia perspective: emerging versus developed markets

In Asia, the approach to Basel 3.1 differs between emerging and developed markets. India and China, for example, have been given a longer timetable to implement the various reforms, whereas developed markets such as Singapore, Hong Kong, Australia and Japan are largely on track to implement along the lines of other developed markets. Japan and Singapore have proposed implementation in early and mid-2024, though that’s likely to be subject to adjustments in order to align with the longer timetable in the US and EU. Hong Kong, meanwhile, has announced plans to implement no earlier than 1 January 2025. 

Generally, there has been little divergence from the Basel 3.1 recommendations, aside from Australia, which has pushed ahead with the operational risk reforms and delayed implementation of the credit valuation adjustment (CVA) and disclosure requirements. 

The banking crisis earlier in the year has sparked a lot of interest in resolution planning, where Asia has lagged somewhat behind its counterparts in the United States, UK and EU. The speed at which events unfolded in the United States, the likelihood of contagion and the loss of access to funds held have caused the Asian central banks to think carefully about what resolution tools they need, what level of coordination is required, and what measures—including backstop measures—should be in place to prepare for those challenges.

While Singapore, Hong Kong, Australia and Japan are reasonably well advanced in terms of resolution tools, readiness to deploy the bail-in option remains challenging in light of the issues identified by the Financial Stability Board’s recent report on the banking crisis. The recent turmoil has prompted a renewed focus on capital instruments, and a recognition that contingent capital instruments need to be fit for purpose and held by appropriate investors. This could mean a move towards some of the same LTD requirements as in the United States, UK and EU.

Future webinars on global trends in financial services and regulation

This was the first in a series of live webinars that Freshfields will be producing over the coming months on global trends in financial services and regulation, featuring lawyers from different regions to give an international perspective on the various topics. Information on the next webinar will be available in due course.