In the world of banking and finance, the term “Basel III Endgame” has been making waves. But what exactly does it mean?
Before delving into Basel III Endgame, it’s important to understand who decides how much capital banks must hold. While banks have some discretion in determining their capital, regulators worldwide impose minimum capital requirements to ensure financial stability.
These requirements are calculated as a percentage of a bank’s assets and serve as a safeguard against insolvency and financial crises. Insufficient capital can incentivize risky behaviour, posing a threat to the banking system. Therefore, regulators aim to strike a balance between ensuring sufficient capital and allowing banks to operate profitably.
The Role of the Basel Committee on Banking Supervision
Basel III is a comprehensive set of measures developed by the Basel Committee following the global financial crisis of 2007-09. These measures aim to strengthen the regulation, supervision, and risk management of banks worldwide.
The final set of rules, known as Basel III Endgame, focuses on the amount of capital banks must hold against credit, operational, and market risks. The Basel III Endgame rules were published for comment by the Federal Reserve, OCC, and FDIC in July 2023, with the intention of aligning US bank capital rules with Basel III standards.
Risk-based capital is a fundamental concept underlying bank capital requirements. It recognizes that different loans and investments carry varying degrees of risk, and banks must hold more capital against riskier assets. This approach aims to prevent a “one-size-fits-all” capital requirement that fails to distinguish between safe and risky activities.
By adjusting the dollar measure of assets to calculate risk-weighted assets, banks can determine the capital requirement percentage. US government bonds, considered low-risk, have a risk weight of zero, while loans to small businesses and homeowners, deemed riskier, have higher risk weights.
Proposed Changes Under Basel III Endgame
The proposed changes under Basel III Endgame are highly technical and span hundreds of pages of regulatory text. However, we will highlight some key elements of the regulators’ proposal. The changes include:
Expanding the scope: The proposal aims to apply the strictest risk-based capital approach to more banks, lowering the threshold from $700 billion to $100 billion in assets. This change would increase the number of banks subject to the requirements and cover approximately 37 large banks in the United States.
Standardized measure for capital requirements: The regulators are seeking to reduce banks’ ability to use their own models to calculate capital requirements for loans. Instead, they propose implementing a standardized measure that applies to all banks, ensuring consistency in risk assessment.
Increased capital for trading and operational risks: The proposal requires banks to hold more capital for risks associated with trading activities and operational challenges. Banks would be required to use standard models to assess these risks, rather than relying on internal models. These changes form a significant portion of the proposed increase in required capital.
Changes to capital calculations for portfolios: Banks with assets of $100 billion or more would need to reflect gains and losses in portfolios designated as “available for sale” in their capital calculations. This adjustment aims to provide a more accurate representation of a bank’s risk exposure.
While the proposal has garnered support from some regulators, including the Federal Reserve Board, there are dissenting voices and reservations among others, particularly from Republican members of the regulatory agencies.
Operational Risk and its Implications
A significant portion of the proposed increase in capital requirements targets banks’ operational risks. Operational risk refers to the potential for loss arising from internal processes, people, systems, or external events. It includes risks such as fraud, compliance failures, cyberattacks, and rogue trading. Under the current rules, only the largest banks are required to hold capital against operational risk. The proposal seeks to raise this requirement for large banks and extend it to more institutions.
Operational risk is measured by a “business indicator” that considers a bank’s size, complexity, and specific activities. Banks with higher business volumes, which are typically larger and more complex, face greater exposure to operational risks. The proposal aims to align capital requirements with a bank’s overall business volume and potential operational risk. However, there are differing opinions on the effectiveness of this approach, with some arguing that regular stress tests already incentivize banks to mitigate operational risks.
Impact on Different Sectors of the Banking Industry
The proposed changes under Basel III Endgame will have varying impacts on different sectors of the banking industry. Banks with large trading, market-making, wealth management, and investment banking operations will be more heavily affected.
These sectors, which engage in activities outside traditional lending, will face greater capital requirements due to the proposed changes in risk assessment and operational risk calculations.
Moreover, specific industries may also feel the effects of the proposed capital requirements. For example, renewable energy companies have raised concerns that increased capital requirements for certain types of lending, such as tax equity investments, could undermine the effectiveness of tax incentives for projects aimed at combating climate change.
Arguments in Favor of Increasing Capital
Proponents of the regulators’ proposal argue that higher capital requirements are essential for safeguarding financial stability. They contend that current capital standards fail to adequately address the risks banks are exposed to, and increased capital can mitigate the likelihood of bank failures and the need for government bailouts.
Higher capital requirements incentivize banks to act prudently, reducing the potential for risky lending practices. In addition, proponents argue that the benefits of a more resilient financial system outweigh any potential negative impacts on lending and profitability.
Economists Stephen Cecchetti and Kermit Schoenholtz emphasize the importance of higher capital requirements in preventing bank failures and promoting stability. They argue that stricter capital and liquidity requirements are necessary due to shortcomings in supervision and potential government interventions.
Their research indicates that increased capital requirements have not hindered banks or borrowers, and any macroeconomic impact has been offset by monetary and fiscal policies. Overall, they find that the social costs associated with higher capital requirements are minimal compared to the benefits of a more resilient financial system.
Arguments Against the Proposal
While there are arguments in favor of increasing capital requirements, there are also dissenting voices and concerns raised against the regulators’ proposal. Some critics argue that the proposed changes may disadvantage banks with business models heavily reliant on fee-based income, such as wealth management. They contend that penalizing banks for past operational losses and requiring them to allocate more capital for operational risks may hinder their ability to compete and provide services.
Furthermore, critics question the need for the proposal’s focus on operational risk and argue that the regular stress tests conducted by regulators already provide sufficient incentives for banks to mitigate these risks. They believe that requiring banks to allocate twice as much capital for operational risks compared to stress test requirements is excessive.
Impact on Mortgages
One area of interest for many is how the proposed changes will impact mortgages. While the regulators’ proposal does not specifically target mortgages, changes to capital calculations and risk-based capital requirements will have indirect effects on mortgage lending. Banks will need to assess the risks associated with mortgage portfolios and allocate the appropriate amount of capital accordingly. The extent of these effects will depend on the size and complexity of a bank’s mortgage lending activities.
Addressing Issues Raised by Silicon Valley Bank
The failures of Silicon Valley Bank and other banks earlier this year have raised concerns about the effectiveness of current capital requirements. Some argue that the proposed changes under Basel III Endgame do not adequately address the issues posed by Silicon Valley Bank and other similar cases. Critics question whether additional capital alone would have been sufficient to prevent these failures and whether the proposal takes the wrong lessons from these incidents. There are ongoing debates regarding the core issues at play and whether the reforms proposed by the regulators address them effectively.
The Road Ahead: What Happens Next?
With the proposal published for comment, regulators will consider feedback from stakeholders and the public. The Federal Reserve, OCC, and FDIC will review the comments and refine the proposal accordingly. The final rule will undergo a vote, likely in the first half of 2024, with implementation scheduled to commence in 2025. It is important to note that the final rule will require broad support from the board members, and adjustments may be made based on economic impact analysis and further deliberation.
