Fed Vice Chair Outlines Recommendations in Basel III Re-Proposal
Commentary by Sebastian Souchet
Federal Reserve Board Vice Chair for Supervision Michael S. Barr outlined his recommendations for a re-proposal of (i) the Basel III endgame and (ii) the proposed adjustments to the Global Systemically Important Bank ("G-SIB") surcharge (collectively, the "July 2023 Banking Proposals").
In a speech at the Brookings Institution, Mr. Barr emphasized the need to adjust the existing July 2023 Banking Proposals based on feedback from a "wide range of stakeholders," including banks, public interest groups and other regulators. He said that the federal banking regulators must strike the right "balance between safety and efficiency"—so that the banking system remains strong, but also that households and businesses don't bear unnecessary burdens. Mr. Barr explained that, in arriving at his recommendations, he worked closely with his counterparts at the FDIC and the OCC to address concerns raised during the initial consultation on the July 2023 Banking Proposals, including concerns that the original proposals would limit credit availability, especially for first-time homebuyers and underserved communities.
Mr. Barr highlighted the following recommended changes:
- Lower Risk Weights for Residential Mortgage Loans and Loans to Retail Customers to better align with the Basel III international standards. He noted that this recommended change addresses commenters' concerns that the elevated risk weights in the July 2023 Banking Proposals (i) overstated the risk profile of such loans (given their loss history), and (ii) could restrict the "availability and affordability of retail credit."
- Lower Risk Weights for Investment-Grade, Non-Publicly Traded Corporate Exposures to increase risk sensitivity in capital requirements. Mr. Barr stated that the re-proposal should include extending reduced risk weights for low-risk corporate exposures to "certain regulated entities that a bank judges to be investment grade and that are not publicly traded." Such entities include pension funds, certain mutual funds and foreign equivalents.
- Reduce Variations in Operational Risk to Capital Requirements to help simplify the calculation of such requirements. Mr. Barr stated that the FRB should "no longer adjust a firm's operational risk charge based on its operational history." He said that (i) the FRB should calculate fee income on a net basis with respect to the operational risk capital requirement; and (ii) reduce operational risk capital requirements for investment management activities.
- Extend Period to Implement Market Risk Tests to "confirm that [banks' internal] models are working as intended." Mr. Barr stated the re-proposal should introduce a "multiyear implementation period for the profit and loss attribution tests." He said this change would enable banks to gain further experience with the tests and provide time to improve banks' systems to address gaps in data and model performance. Further, to enable banks to recognize hedging across uniform mortgage-backed securities positions, such positions should be treated as having a single obligor (regardless of being issued by Fannie Mae or Freddie Mac).
- Reduce the Capital for Certain Derivatives to better reflect the risk of transactions. Mr. Barr said the FRB should reduce the capital required for the client-facing leg of certain client-cleared derivatives.
Regarding the G-SIB surcharge proposal, Mr. Barr would make adjustments aimed at more accurately reflecting a bank's systemic risk profile, including: (i) not adopting the previously proposed changes to capital requirements applicable to client-cleared derivatives; and (ii) accounting for inflation and economic growth so that a G-SIB's surcharge "would not change based simply on growth in the economy."
Mr. Barr stated that a re-proposal would also include a recalibration of capital requirements based on the FRB's tailoring framework. Under a re-proposal, G-SIBs and other internationally active banks would continue to be subject to the most rigorous requirements, including "the new credit risk and operational risk requirements, [and the revised] frameworks for market risk and [credit valuation adjustments]." For non-G-SIB firms with assets between $250 billion and $750 billion, he said the revised market risk and credit valuation adjustment frameworks should only apply if such firms engage in significant trading activity. He said that banks with assets between $100 billion and $250 billion should not be subject to the credit risk and operational risk frameworks of the expanded risk-based approach.
Mr. Barr concluded that the "broad and material changes" to the July 2023 Banking Proposals "would better balance the benefits and costs of capital in light of comments received, and result in a capital framework that appropriately reflects the risks of bank activities and is tiered to the banking sector." He emphasized that the recommended changes would more broadly align the July 2023 Banking Proposals with other major jurisdictions' implementation of the Basel III requirements. Mr. Barr said before finalizing any rules, the federal banking regulators intend to accept public comments on any aspect of the Basel III endgame and G-SIB surcharge proposals.
Commentary
Mr. Barr's speech effectively confirms what has been telegraphed over the past year by the federal banking regulators—there will be a material re-proposal of the so-called Basel III endgame.
A few additional highlights from Mr. Barr's speech (and the Q&A session that followed):
- Overall Capital Impact. Mr. Barr states that the re-proposals will increase aggregate CET1 capital requirements for the G-SIBs by 9%, and that large non-G-SIB firms would ultimately see an estimated 3% to 4% increase in their capital requirements mainly as a result of the inclusion in regulatory capital calculations of unrealized gains and losses on their securities (see p. 3). These estimated increases are substantially less than the estimated increases under the original proposal—i.e., 19% for U.S. G-SIBs and 6% for non-G-SIB firms with assets between $100 billion and $700 billion.
- Tailoring. Various commenters, as well as some FRB Governors and other senior bank regulatory officials, raised concerns that the Basel III endgame amendments, as originally proposed, would materially reverse the FRB's tailoring of the capital framework for large banks. Indeed, under the original proposal, Category III and Category IV firms would be subject to various new requirements that are currently generally applicable only to US G-SIBs (see previous coverage). Mr. Barr's speech specifically addresses some of these tailoring concerns, as he plans to recommend that: (i) Category III firms would still be subject to new credit risk and operational risk requirements, while the new market risk and CVA frameworks would only apply to Category III firms that engage in significant trading activity; (ii) Category III and Category IV firms would not be subject to the expanded definition of regulatory capital applicable to G-SIBs, with the exception of having to reflect AOCI in regulatory capital; and (iii) Category IV firms would not be subject to the Basel III endgame changes, subject to potential application of the revised market risk framework where a Category IV firm has significant trading operations (see pp. 3-4; 9-10).
- Securities Financing Transactions and Treasury Clearing. Mr. Barr said that he would recommend the FRB not adopt the capital treatment associated with minimum haircut floors for certain securities financing transactions. (He explained that not adopting the minimum haircut floor framework would enable the federal banking regulators to seek greater international consensus on the issue before determining whether and how to implement such requirements in the United States.) Note: This recommendation is particularly important in light of the SEC's recently adopted central clearing requirements for US Treasuries and Treasury repo transactions. Minimum haircuts for Treasury repos could have constraining impacts on Treasury repo market liquidity (assuming such haircuts, if implemented, would have applied to repo-style transactions with US sovereign collateral underlying). That being said, it remains an open question as to whether the re-proposal will consider other impacts of the SEC's Treasury clearing requirements on banks, particularly with respect to supplementary leverage ratio requirements and the availability of cross-product margining and netting.
- Digital Assets. Mr. Barr provided no guidance on whether a re-proposal would address how large banking organizations might incorporate digital asset holdings into their regulatory capital calculations.
- Comment Period. The re-proposal would have a 60-day comment period.