After several years of anticipation, the Federal Reserve Board (“FRB”), Federal Deposit Insurance Corporation (“FDIC”) and the Office of the Comptroller of the Currency (“OCC”) (the “Agencies”) issued for comment a long-awaited proposal (the “Capital Proposal”) on the U.S. implementation of the so-called Basel III endgame. The FRB also issued a proposal related to the capital surcharge for the eight largest U.S. global systemically important bank holding companies (“GSIBs”) (the “GSIB Surcharge Proposal”). Comments on each proposal are due on November 30, 2023.
As discussed in more detail below, the Capital Proposal, including the new “expanded risk-based approach,” would generally be applicable to banking organizations (including banks, bank holding companies and intermediate holding companies of foreign banks) with $100 billion or more in assets. The Agencies expect the Capital Proposal would increase risk weighted assets (“RWA”) by 20% relative to currently binding measures of RWA across holding companies subject to the proposal. While the Agencies expect the bulk of this increase to be borne by the U.S. GSIBs, Category III and IV banking organizations (those between $100 billion and $700 billion in assets) would also see material increases in RWA coupled with the significant costs associated with building out capabilities to comply with the new requirements. The rules would also add significant operational risk capital burdens to all banks subject to the Capital Proposal, which could hamper their ability to grow, organically or through acquisition, nonbank revenue sources such as investment advisors and broker dealers. Overall, the Capital Proposal is likely to face significant pushback, but if enacted substantially as proposed likely would warrant banks revisiting approach to growth and strategic objectives.
At one time, the Capital Proposal was expected to be capital neutral. Because the current proposal would lead to materially increased capital requirements and other impacts, many senior Agency members issued unusual and fiery dissents in connection with the votes to issue the Capital Proposal. In particular, FDIC Vice Chairman Hill and Director McKernan voted against issuing the Capital Proposal, as did FRB Governors Bowman and Waller. They cited concerns about unintended consequences, including increased costs to the real economy and the financial system, and “gold-plating” Basel Committee on Banking Supervision (“BCBS”) requirements that would put U.S. banking organizations at a competitive disadvantage.
Although the remaining FRB governors voted for the Capital Proposal, each, with the exception of FRB Vice Chair for Supervision Michael Barr, expressed at least some concern with the Capital Proposal. FRB Chair Powell noted potential costs and the lack of alignment with other jurisdictions’ implementation of the BCBS’ 2017 proposal. Governor Cook asked FRB staff pointed questions about the particularly conservative treatment of residential real estate exposures and differences from other jurisdictions’ proposals. Finally, Governor Jefferson caveated his vote supporting the issuance of the Capital Proposal, noting that he would evaluate any potential final rule on its merits.
Below, we highlight certain notable aspects of each proposal, which we expect to supplement in the coming weeks. This level of public dissent as to a significant regulatory proposal is highly unusual and noteworthy.
Basel III Endgame Proposal
The Capital Proposal sets forth the Agencies’ proposed approach to implementing the BCBS 2017 revisions to the Basel III framework, originally introduced in 2010 (the “Basel Framework”). While the BCBS initially expected the revisions to the Basel Framework to be implemented by member jurisdictions by January 2022, that date was delayed repeatedly, including due to the COVID-19 pandemic.
Although the Capital Proposal appears largely consistent with the Basel Framework, the Agencies’ have gold-plated requirements in a number of notable respects. Even where the Proposal aligns with the Basel Framework, the changes would represent a significant increase in capital requirements, compared to the current U.S. framework.
– With very limited exceptions, the core changes would be applicable to banking organizations (including banks, bank holding companies and intermediate holding companies of foreign banks) with $100 billion or more in assets.
– The Capital Proposal would remove the exemption that currently allows intermediate holding companies that otherwise meet the applicable thresholds not to calculate capital requirements under the advanced approaches.
– The market risk capital (but not credit valuation adjustment (“CVA”) capital) component of the Capital Proposal also would apply to all banking organizations (including those with less than $100 billion in assets) that had $5 billion (up from $1 billion) or more in trading assets and liabilities (calculated as an average over the previous four quarters) or that had trading assets and liabilities of 10% or more of the organization’s total consolidated assets at the end of the most recent quarter, in each case excluding trading assets and liabilities attributable to customer and proprietary broker-dealer reserve bank accounts.
Effective Date. The final rules are intended to be effective July 2025, with a three-year transition period, such that the requirements of the rule would be fully phased in beginning in July 2028.
Summary of Agencies’ Quantitative Impact Study
– The Agencies’ quantitative impact study performed in connection with the Capital Proposal anticipates that the proposal would significantly increase capital across affected firms, including that it would:
– Increase RWA by 20% relative to currently binding measures of RWA across holding companies subject to the Capital Proposal, with the bulk of the increase being borne by the largest firms: the estimated increase in RWA is 25% for Category I and II firms, 6% for domestic Category III or IV firms and 25% for intermediate holding companies of foreign banking organizations subject to Category III and IV standards;
– Increase binding common equity tier 1 (“CET1”) capital requirements, including minimums and buffers, by 16%.
– Increase required risk-based capital ratios related to lending activities by 30 basis points.
– Increase required risk-based capital ratios related to trading activities by 67 basis points.
– Increase average total loss absorbing capacity (“TLAC”) requirements for U.S. GSIBs by 15.2%.
– As explained further below, the Capital Proposal would replace the current advanced approaches with a new expanded risk-based approach. The Agencies estimate that this new approach would become the binding constraint for most large banking organizations.
Core Changes. The two core conceptual changes contemplated by the Capital Proposal are: (1) replacement of the current advanced approaches with an expanded risk-based approach that removes the availability of internal models for credit and operational risk and applies to all banks with $100 billion or more in assets; and (2) replacement of the current market risk capital framework with a revised framework and the addition of a separate capital requirement for CVA risk.
– Consistent with the Collins Amendment to the Dodd-Frank Act, an institution’s regulatory capital ratio would be the lower of the two calculated based on the current standardized approach and new expanded approach. Stated differently, a banking organization subject to the proposal would have to apply the result of the worse of the two measures in determining whether it meets relevant capital requirements.
– The FRB’s Comprehensive Capital Analysis and Review exercise, which helps to set firms’ stress capital buffer (“SCB”) requirement, would be based on both the standardized and expanded frameworks, with the SCB requirement then being applied on top of the binding constraint (independently of whether the SCB stress loss minimum resulted from the standardized or expanded calculation). Similar changes would be made to the FRB’s company-run stress testing and capital plan frameworks.
Output Floor. As noted above, the Capital Proposal would replace the existing advanced approaches with the new expanded risk-based approach and a revised market risk framework, the latter of which would continue to allow use of internal models. The expanded approach would be subject to an output floor that would provide a limit on the extent to which internal models can reduce a firm’s expanded requirements. To operationalize the output floor, RWA under the expanded risk-based approach would be equal to (subject to certain exclusions) the greater of:
– The sum of the expanded credit, equity, operational, CVA and market RWA; and
– 72.5% of the sum of the expanded credit, equity, operational and CVA RWA and the standardized market RWA calculated under the expanded approach, less adjusted allowance for credit losses not included in tier 2 capital and allocated transfer risk reserves.
SLR and CCyB. In addition, Category IV organizations (those with between $100 billion and $250 billion in assets) would be subject to the supplementary leverage ratio of 3% and the countercyclical capital buffer (currently set at 0%).
Conforming Changes. In addition to proposing changes to the Agencies’ capital rules, the Capital Proposal would make conforming changes throughout the capital rule resulting from the application of requirements previously only applicable to advanced approaches firms to Category III and IV banking organizations, as well as to FRB Regulations H, Y, LL and YY (including the single-counterparty credit limits).
Numerator (Composition of Capital)
AOCI. Category III and IV banking organizations would no longer be eligible for the accumulated other comprehensive income opt-out and would have to include unrealized losses and gains on their available-for-sale securities in their capital (but would be required to ignore any AOCI gains and losses resulting from certain cash flow hedges).
Conforming Changes. Many of the changes to the numerator requirements would be the consequence of applying requirements currently applicable to advanced approaches firms to Category III and IV banking organizations, including those related to deductions for investments in the capital of unconsolidated financial institutions, minority interest capital, deduction for TLAC instruments and certain capital instrument disclosures.
Denominator Changes (Risk Weighted Assets)
– The expanded approach would include RWA for credit risk, equity risk, operational risk, CVA risk and market risk. Below, we summarize some of our observations on each component.
– The Capital Proposal generally aligns with the Basel Framework, but are gold-plated in several notable regards.
– The Capital Proposal would remove the availability of internal models for credit risk, which the Agencies estimate would result in a significant increase in capital requirements compared to the current advanced approaches. In contrast, Basel Framework (and the UK and EU proposals) limit, but do not eliminate, the usage of credit risk models.
– The Capital Proposal proposes higher risk weights for residential real estate exposures (20 percentage points across the board), regulatory retail (10 percentage points) and short-term bank exposures, including correspondent deposits (25 percentage points or more).
– Other notable deviations include: (1) a requirement that corporate issuers (or their parent companies) of financial collateral in the form of corporate debt have publicly traded securities outstanding; (2) lack of a separate risk weighting category for regulated financial institutions, such as broker-dealers (historically the U.S. has deviated from the BCBS in this regard); and (3) requiring firms to estimate the amount of unfunded commitments with no preset max using a prescribed averaging methodology.
– Even where consistent with the Basel Framework, the Capital Proposal could result in significantly higher capital requirements compared to the current U.S. advanced approaches, or even the standardized approach. These changes include:
– To take advantage of the more favorable 65% risk weight for investment grade corporate exposures (the default risk weight is otherwise 100%), the obligor (or its parent) must have a publicly traded security outstanding (the EU and UK proposals have eliminated this requirement);
– Introduction of a subordinated debt asset class category risk-weighted at 150%;
– Introduction of a framework for project finance exposures (generally risk-weighted higher than general corporate exposures);
– A more stringent definition of “defaulted exposure;”
– Removal of modelled approaches for credit risk mitigation, which historically have resulted in significantly lower and more risk-sensitive capital requirements for such transactions;
– Replacement of the collateral haircut approach for eligible margin loans and repo-style transactions with a more risk-sensitive approach, but not making conforming changes to the current standardized approach;
– Replacing the existing approaches for calculating capital requirements for securitizations with an approach based on the Basel Framework’s SEC-SA approach, which is similar to the current simplified supervisory formula approach but notably increases the supervisory p-factor for non-resecuritizations from 0.5 to 1 (under the Basel Framework’s modelled approaches for securitization exposures, the supervisory parameter, which is floored at 0.3, is calculated based on a variety of factors relating to the economic characteristics of the tranche and the underlying pool – a higher supervisory p-factor results in a higher capital requirement);
– Introducing minimum haircuts for securities financing transactions with unregulated financial institutions, subject to certain exceptions, including for transactions in which a banking organization borrows securities for the purpose of meeting a current or anticipated demand (which would be a deviation from the Basel Framework) – the UK and EU both have refrained from proposing such minimum haircuts pending further data collection; and
– Increasing the credit conversion factor (from 0% to 10%) for unconditionally cancellable commitments and setting the credit conversion factor for commitments at 40% regardless of maturity.
– Consistent with Basel Framework, the Capital Proposal would remove the modelled approaches for equity risk.
– As discussed further below, the Capital Proposal would require certain publicly traded equity exposures and equity exposures to investment funds to be capitalized under the market risk capital framework, regardless of trading intent.
– The Capital Proposal largely retains the non-modelled approaches, with certain modifications, including by removing the potential 100% risk weight for non-significant equity exposures.
Credit Valuation Adjustment.
– The Capital Proposal’s CVA framework is based on the Basel Framework’s basic CVA and standardized CVA approaches, with certain conforming changes based on U.S. market conventions (e.g., by excluding securities financing transactions from the framework).
– Category III and IV firms currently are not subject to any CVA capital requirement, and building out capabilities to calculate this capital requirement may be costly notwithstanding that the Agencies’ do not estimate significant contributions to risk weighted assets based on this requirement.
– The Agencies did not propose any exemptions or reduced risk weights for commercial end-users, such as those proposed in the UK.
– Consistent with the Basel Framework, the Capital Proposal would replace the advanced measurement approaches, which were based on a banking organization’s internal models and were available to the largest banks, with a standardized approach for operational risk applicable to all banking organizations with $100 billion or more in assets.
– Based on the Agencies’ impact study, operational requirements would decrease for Category I and II firms (currently subject to modelled approaches), but would increase for Category III and IV firms (by virtue of the fact that such firms currently are not required to separately capitalize operational risk).
– Even if the impact of such requirements is neutralized, building out the systems to comply with the operational risk management and operational loss event data collection is likely to be a significantly (and costly) undertaking.
– The requirements under the standardized approach would be a function of a banking organization’s business indicator component and internal loss multiplier (“ILM”). The proposal explains that the business indicator component would be calculated based on a banking organization’s business indicator multiplied by scaling factors that increase with the business indicator.
– Significantly, the business indicator would capture a firm’s activities that generate fees and commissions, including insurance activities. This is consistent with the Basel Framework but could effectively penalize banking organizations with significant fee-generating activities.
– With regulatory approval, banking organizations would be allowed to exclude losses associated with discontinued business subject to demonstration that the activity does not carry legacy legal exposure.
– Although largely consistent with the Basel Framework, the Agencies did not adopt certain optionality permitted to national supervisors by the BCBS, including the following:
– The ILM would be floored (but not set at) 1—the UK and EU each proposed to set the ILM at 1 (although practically unlikely, an ILM of below 1 could result in a lower capital requirement).
– The business indicator would include insurance income (whereas the Basel Framework would exclude insurance and reinsurance income and expenses).
– The Capital Proposal would include a requirement to estimate operational losses for acquired companies that do not have sufficient data.
– The FRB has not yet provided detail on how the new operational risk capital framework would be reconciled with the operational risk components of the CCAR (which currently flow through pre-provision net revenue).
– The market risk capital framework in the Capital Proposal is based on the framework set out in the Basel Framework, but also includes certain notable deviations or elaborations.
– Based on the Agencies’ impact study, market risk capital requirements are expected to drastically increase compared to current market risk capital requirements.
– For example, the Proposal would expand the definition of market risk covered position to require holding publicly traded equity positions (other than those with restrictions on transferability) and equity investments in funds (other than those where the banking organization has insufficient information on the fund’s underlying holdings) in the trading book, which could have significant implications for banking organizations Volcker Rule compliance.
The GSIB Surcharge Proposal
Proposed Changes. Consistent with changes to the GSIB surcharge that Vice Chair Barr had previewed, the GSIB Surcharge Proposal would make three main changes to the FRB’s GSIB surcharge rule and to the FR Y-15 (the Systemic Risk Report), including changes to: (1) data averaging; (2) method 2 calculations to reduce cliff effects; and (3) the content of some systemic indicators.
Data averaging. The proposal would no longer use a December 31 point-in-time end-of-year reporting date for systemic risk indicators. Rather, they will be measured using an average of the four quarterly values for the year. Further, the U.S. GSIBS would be required to measure certain indicators on a daily basis and for certain off-balance sheet items would measure based on the month-end exposure amounts.
Reducing cliff effects. The proposal would measure method 2 GSIB surcharges in 10-basis point increments instead of 50-basis point increments. The Agencies note that this proposed change is not designed to alter the overall calibration of the method 2 surcharge. The proposal would not change the score band ranges for method 1.
Systemic indicator changes. The proposal would make changes to the measurement of some systemic indicators on the FR Y-15. Of the five categories used to calculate method 1, four categories would be impacted—interconnectedness, complexity, substitutability and cross-jurisdictional activity. The short-term wholesale funding category for method 2 would also be impacted. In many instances, these changes expand the scope of what is covered and could affect a banking organization’s tailoring categorization.
Additional Changes. The FRB seeks comment on whether the FRB should modify the effective date of changes to a firm’s GSIB surcharge requirement following a change in its GSIB score (under the current framework, an increase in the GSIB surcharge takes effect on January 1 of the year that is one full calendar year after the increased GSIB surcharge was calculated) and proposes certain clarifying changes for when the GSIB surcharge requirement is adjusted.
Impact. Under the proposal, the FRB anticipates the U.S. GSIBs would see small changes to their GSIB capital surcharges, estimated by FRB staff to range from –10 to +40 basis points.
Relevance to Organizations other than GSIBs. The changes to the FR Y-15 generally would be relevant to all filers of the FR Y-15 (not just the U.S. GSIBs) and could affect the categorization of FR Y-15 filers and applicable requirements under the regulatory tiering framework for large banking organizations. In particular, the FRB anticipates that the changes to cross-jurisdictional activity would move seven foreign banking organizations that are currently subject to Category III or IV standards to Category II and two U.S. intermediate holding companies of foreign banking organizations that are currently subject to Category III standards to Category II.
Effective date. There would be no change to the effective date of calculation and surcharge requirements from the current rule (the proposal does consider changes to the effective date of an adjusted GSIB surcharge, as noted above). The changes to FR Y-15 reporting would be effective two full quarters after adoption of the final rule.
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