Federal Banking Agencies Propose Increased Capital Requirements for Large Banks

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.