Federal Banking Agencies Propose Increased Capital Requirements For Large Banks – Charges, Mortgages, Indemnities

In Short

The Situation: The federal banking agencies
approved a proposal that would implement a “gold-plated”
U.S. version of the “Basel III endgame.”

The Result: If adopted, the proposal would
increase aggregate capital held by large banks by 16% (per agency
estimates) and dramatically change how banks allocate capital as
well as the pricing and availability of financial services and
products. It also could have a serious impact on the role banks
play in the financial system and the overall stability of that
system.

Looking Ahead: Banks should consider (i)
assessing the potential impact of the proposal on their products
and services; (ii) preparing to explain these expected impacts to
Congress, the agencies, and other stakeholders; and (iii) preparing
a range of potential responses during the proposal stage and, if
necessary, after a capital rule is finalized.

On July 27, 2023, the federal banking agencies approved a notice
of proposed rulemaking to implement the remaining Basel III
framework, referred to as the Basel III endgame. The proposal
covers risk-weighted asset calculations for credit, market, credit
valuation adjustment (“CVA”), and operational risks. It
also seeks to align capital rules more generally for all firms with
$100 billion or more in assets. In so doing, the proposal
explicitly rejects a “capital neutral” approach and
instead gold-plates Basel standards. Agency staff estimate that
banking organizations with $100 billion or more in assets will see
an aggregate increase of 16% for Common Equity Tier 1 capital.

If adopted, the proposal would have a substantial impact on how
banks allocate capital, the pricing and availability of financial
services and products, the role played by banks in the larger
financial system, and the stability of the system as a whole.

Among other notable features of the proposal:

• The proposal eliminates any tailoring of the capital rules for
  banks with $100 billion or more in assets other than U.S. G-SIBs,
  effectively collapsing current Federal Reserve categories II, III,
  and IV. These categories cover banks with assets of $100 billion or
  more that are not U.S. G-SIBs and distinguish further based on
  asset size (including nonbank assets), cross-jurisdictional
  activity, off-balance sheet exposures, and funding type.
  

  • The new Basel standard would apply to all of the $100
    billion-plus banks regardless of size or complexity, including
    application of the market risk requirements to banks with de
    minimis trading activities.

  
  

  • In addition, the proposal would subject all of these banks to
    the supplementary leverage ratio, countercyclical capital buffer,
    and accumulated other comprehensive income, or AOCI. For example,
    all large banks would have to incorporate unrealized losses and
    gains on available for sale securities in their capital
    requirements. This may be the only portion of the proposal that
    relates directly to the bank failures and industry turmoil of early
    2023.

  
  

  • In so doing, the proposal appears to flout the Congressional
    intent of Section 165 of the Dodd-Frank Act, as modified by the
    2018 Economic Growth Act, that the Federal Reserve tailor enhanced
    standards for banks of $100 billion or more in assets.
    




• The proposal replaces the current “advanced
  approaches” that permitted banks to use their own internal
  models to calculate risk-weighted assets (“RWAs”) with a
  new “expanded risk-based” approach based on the Basel III
  “standardised” approach that largely eliminates the use
  of internal models. The expanded risk-based approach would apply to
  all banks with $100 billion or more in assets and will raise
  capital costs by:
  

  • Gold-plating credit risk weights for residential mortgages,
    retail exposures, exposures to banks and credit unions, and
    exposures to small businesses;

  
  

  • Adopting minimum haircut floors for securities financing
    transactions (unlike European jurisdictions that declined to adopt
    them);

  
  

  • Eliminating the use of internal models in calculating credit
    and operational risk;

  
  

  • Setting a floor for operational risk weights based on
    historical losses via the internal loss multiplier; and

  
  

  • Using the standardized approach for market risk weights as a
    default in lieu of an internal-model approach, with internal models
    only permitted with new restrictions.
    




• Large banks will have to determine their capital requirements
  under both the expanded risk-based and existing U.S. standardized
  approaches, and hold capital in excess of whichever approach would
  produce the higher level of capital, together with applicable
  buffers and surcharges.
  




• Banks will have a three-year transition period beginning in
  July 2025 to comply with the new requirements. However, market
  pressures may drive banks to comply earlier with the new
  requirements or at least clarify how they will meet the new capital
  requirements long before the transition period concludes.

Unlike the general consensus in support of the earlier Basel III
reforms that increased the quality and quantity of capital
immediately following the 2008 crisis, the current proposal has
been met with widespread criticism even before its release and
notable dissents from members of the Federal Reserve and FDIC
boards. These criticisms have included both procedural and
substantive concerns. Critics have questioned the rationale and
timing for such a capital hike as well as the trade-offs between
any marginal increases in resiliency on the one hand and impact to
pricing and availability of credit and other financial services and
products on the other. Details of the holistic capital review
conducted by Federal Reserve Vice Chair Michael Barr on which the
capital increase is premised have been scant (as well as any
associated cost-benefit analysis), and attempts to justify it as a
response to earlier bank failures this year have been unpersuasive.
The proposal’s capital increase is also inconsistent with views
expressed by Biden administration and federal banking agency
officials that the banking industry is well-capitalized, as well as
the original sentiment that the remaining Basel III reforms would
not significantly increase capital requirements. Others have raised
concerns with the legality of the overall U.S. capital framework
itself, of which this proposal would form a part.

Banks should consider assessing the comparative and absolute
impact of the proposal on their unique product and service
offerings and be prepared to articulate the impact of increased
capital on them, their customers, and counterparties to Congress
and the agencies. Concerned customers and counterparties should
likewise consider weighing in, given the intermediary role that
banks play in our financial system and the primary importance of
capital regulation on everything banks do. Whether public comments
alter the contours of the final rule or not, they will form part of
the agencies’ rulemaking record and provide a basis for
potential future challenges in court.

Comments are due on the proposal by November 30, 2023.

Four Key Takeaways

1. The “Basel III endgame” proposal, if adopted, would
   apply to all banks of $100 billion in assets or more, including
   those banks that fall within the Federal Reserve’s current
   categories II, III, and IV.




2. The proposal introduces an “expanded risk-based”
   approach to calculating RWAs for purposes of credit, market, CVA,
   and operational risk that limits the use of internal models and
   raises capital costs.




3. The proposal would also require large banks to calculate their
   RWAs under the existing U.S. standardized approach and hold capital
   in excess of the higher of the two approaches.




4. Banks would have a three-year transition period beginning in
   July 2025 to meet the new requirements, but they will need to
   assess their options for responding to the proposal and to any rule
   that is finalized much sooner.

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