Bank Capital Requirements: Basel III Endgame

Setting bank capital requirements is an iterative process. Requirements have repeatedly been tweaked over the decades as problems emerge or policy priorities change. For example, in 2013 U.S. regulators began implementing what is known as Basel III, a new capital framework aimed at addressing many of the issues believed to precipitate the global financial crisis. The latest recommendations of the Basel Committee on Banking Supervision (BCBS) were finalized in 2017. These recommendations fill in some of the more technical details of Basel III and are sometimes colloquially referred to as the Basel III Endgame. On July 27, 2023, the federal banking regulators—the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and the Federal Reserve (Fed)—jointly issued a proposed rule that would revise large bank capital requirements. In addition to implementing the Basel III Endgame, the proposal would implement some of the recommendations that Fed Vice Chair Michael Barr proposed in a previous holistic capital review and respond to issues that arose when three banks with over $100 billion in assets failed in 2023. The proposal would apply to banks with over $100 billion in assets. According to the proposal, its purpose is to improve the consistency of capital requirements across banks, better match capital requirements to risk, reduce their complexity, and improve transparency of banks’ financial conditions for supervisors and the public. In the United States, the largest banks calculate their requirements using two methods: a standardized approach applicable to all banks and a specialized advanced approach that allows the banks to model many of their own risks. Although internal models can potentially be “gamed” (i.e., designed in a way to allow a bank to hold less capital rather than accurately measure risk), they can also model risk more sophisticatedly and be more tailored to a bank’s unique risk profile. Following the Basel III Endgame, the proposed rule would reduce the use of internal models through a new second standardized approach for advanced approaches banks called the expanded risk-based approach. Other banks with over $100 billion in assets would be required to calculate risk-weighted assets under two approaches for the first time. Despite the regulators’ intentions, many within the industry have criticized this dual approach to capital requirements as unduly burdensome. The proposal would also require banks with over $100 billion in assets to include unrealized capital gains and losses on certain securities in their capital levels. Unrealized capital losses were one of the primary causes of Silicon Valley Bank’s failure. The proposal would also extend two capital requirements—the supplementary leverage ratio and countercyclical capital buffer—to all banks with over $100 billion in assets. One criticism of the proposal is that it is not capital neutral but, rather, would require subjected banks to hold more capital. Although the proposal does not raise required capital ratios, the regulators estimate that its effect on risk-weighted assets would increase the average binding CET1 capital level large banks are required to hold by 16%. Note that (1) this estimate is an average, and the effects on any particular bank would differ; and (2) this is an estimate based on past data—the actual effect would depend on future actions by the banks, including how they responded to the rule. The proposal would have a larger capital effect on trading activities than on lending, and it is estimated to have the largest effect on globally systemically important banks. Concerns about how specific changes to risk weights affect specific asset classes have also been raised, along with a few other criticisms. Critics have argued that (1) the proposal (and existing requirements) has “gold-plated” Basel provisions, such as risk weighting for residential mortgages, making them more stringent than the BCBS agreements; (2) the proposal is largely not tailored to reflect differences in risk and complexity among large banks; and (3) regulators have not provided the public with enough information on the basis for the specific details of the requirements.