Michael Barr, vice chair for supervision at the Federal Reserve, left, shakes hands with Martin Gruenberg, chair of the Federal Deposit Insurance Corporation at a Senate Banking hearing in May. The Basel III endgame proposal issued by the Fed, FDIC and Office of the Comptroller of the Currency would raise capital significantly for the largest banks, but there are several ways that the rule's opponents will try to stop it.
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The Basel III endgame is entering its end stage.
Tuesday, Jan. 16 is the deadline for the public to comment on a joint proposal from the Federal Reserve, Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency that would rewrite capital obligations for all banks with at least $100 billion of assets.
Put forth in July, the proposal would force the affected banks to increase their aggregate Tier 1 equity capital by 16%, with the largest, global systemically important banks bearing the brunt of the increase, seeing their capital levels bumped by 19%.
Banks have pushed back hard against the potential rule change, as have congressional Republicans and other interest groups outside the banking space, including those representing small business, multinational corporations and the real estate sector. Their issues are multifaceted, but the primary arguments raised are that the rule goes too far and would force banks to pull back on lending. Some have also raised procedural concerns with the proposal.
Supporters of the reforms say the changes are necessary to close gaps in the current regulatory framework, which were laid bare during a run of bank failures earlier this year. By their estimate, the benefits of a safer banking system outweigh the potential costs — which regulators project would be minimal. Federal Reserve Vice Chair for Supervision Michael Barr said the average lending portfolio would see its required capital increase by 3 basis points, or 0.03%, while the bulk of the capital increase would be derived from trading and investment activities.
Regulators attached a litany of questions to the proposed rule change for the industry and the public at large to weigh in on. Once the comment period closes, the agencies will set to work absorbing those comments and absorbing them into a final rule.
In a recent public appearance, Barr emphasized the importance of the comment period and noted that he and his fellow regulators are paying close attention to the feedback being given.
"We have already heard concerns that the proposed risk-based capital treatment for mortgage lending, tax credit investments, trading activities, and activities that generate fee-based income might overestimate the risk of these activities," Barr said. "We welcome all comments that provide the agencies with additional data and perspectives to help ensure the rules accurately reflect risk."
The agencies are on track to put a final rule to a vote at some point in 2024, likely in the first half of the year. The proposal calls for implementation to start in 2025 with a three-year phase-in period. But there is much for policymakers to work through before reaching that point.
Below are the top storylines related to the Basel III endgame to track in the year ahead.
The failures of Bear Stearns and Lehman Brothers in the months leading up the the Great Financial Crisis led policymakers to focus on increasing bank capital, and the failures of Silicon Valley Bank and other this spring has renewed that desire among regulators. But opponents to the Basel III endgame proposal say the proposal takes the wrong lessons from this spring's bank failures.
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GFC vs. SVB
Because of their proximity to one another, the proposed capital reforms have sometimes been viewed as a response to the failures of three large banks this past spring. But that is not entirely accurate.
The Basel III endgame, as its name suggests, is rooted in the most recent global standards issued by the Basel Committee on Banking Supervision. Those standards are themselves an extension of a regulatory reform effort that emerged from the subprime mortgage crisis and ensuing global financial fallout. The primary purpose of the proposal is to align the U.S. with its global peers.
In a speech to the American Bankers Association in October, Fed Vice Chair for Supervision Michael Barr framed the proposal as an effort to "comprehensively address the lessons of the global financial crisis."
Yet, regulators have also invoked the failures of Silicon Valley Bank and others in their remarks about the need for capital reform. When the proposal was put forth to the public, Barr cited the episode as proof that higher capital requirements are in order.
"As we learned earlier this year, banks with inadequate levels of capital are vulnerable, and that vulnerability can cause contagion, which threatens the stability of the banking system and hurts families and businesses," Barr said, adding that a "clear message" from the failures was that "regulatory requirements, including capital requirements, must be aligned with actual risk so that banks bear the responsibility for their own risk-taking."
The bank failures, which include three of the four biggest in U.S. history, encapsulated the systemic risk posed by banks that are considered too big to fail. They also injected a sense of timeliness to reforms aimed at addressing a decade-old crisis. But the correlation has opened regulators up to criticism, especially in light of the assessment that additional capital alone would not have been to help Silicon Valley Bank or Signature Bank withstand their massive runs they faced.
In Congress, some Republicans have said the reform package is proof that regulators have learned the wrong lessons from the failures. During a Senate Banking Committee hearing in November, Sen. Steve Daines, R-Mont., admonished Barr, FDIC Chair Martin Gruenberg and Acting Comptroller of the Currency Michael Hsu for pursuing reforms that he felt did not address the core issues at play.
"We saw the bank failures earlier this year, I believe, as a result of regulators being asleep at the switch, as we probed in great depths in many of these failures," Daines said. "It's clear these failures were not due to insufficient capital. Nevertheless, you're moving forward with a flawed Basel III endgame proposal."
David Sewell, a partner at the law firm Freshfields Bruckhaus Deringer and a former regulatory and supervisory lawyer with the Federal Reserve Bank of New York, said using the regional banking crisis of this spring to give new life to longstanding bank regulatory priorities was a running theme throughout 2023. He noted that expanding resolution plans and long-term debt requirements are also examples of pre-existing agenda items that have been colored by the "specter of Silicon Valley."
Sewell said the failures did expose gaps in the regulatory framework, particularly for banks with between $100 billion and $250 billion of assets. But, he added, the scope of the crisis was ultimately limited to three banks, a fact that could give the impact of the episode a relatively short shelf life.
"Those three banks and their experiences have been informing the whole conversation," Sewell said. "As we get deeper into 2024 and those memories start to fade, I wonder if it will feel as immediate as policymakers are looking at these bigger picture issues."
The Bank of England and European Union have adopted Basel III implementation rules that require far lower capital raises than their U.S. counterparts, a development that opponents to the U.S. rule say demonstrate that it has gone too far.
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The competitive landscape
With a proposed cumulative capital increase of 16% across impacted banks, the U.S. version of the Basel III endgame standards is poised to be more stringent than its equivalents in the UK and the Eurozone, which are looking at increases of roughly 3% and 10%, respectively.
Under the Basel Accords, different regulatory jurisdictions are given national discretion to increase or decrease certain components of the framework based on their own needs and preferences. How U.S. regulators calibrate their implementation relative to their counterparts across the Atlantic figures to play a role in the debate over capital requirements.
American banks and their allies say the standards put forth by Washington regulators amounts to "gold-plating" of the international guidelines. They argue the disparities will deepen the longstanding competitive disadvantage U.S. banks have relative to their overseas peers.
In public remarks at the Barclays Global Financial Services Conference in September, JPMorgan CEO Jamie Dimon said the approach taken by the Fed, FDIC and OCC undermines the founding intent of the Basel Committee: to standardize bank regulation around the world.
"What was the goddamn point of Basel in the first place?" Dimon said.
But proponents of the proposed reforms — including academics, consumer advocates and other industry participants — say higher capital requirements could benefit the bottom lines of U.S. banks by improving their credit ratings, thus decreasing their borrowing costs and bettering their positions on derivatives.
Mayra Rodríguez Valladares, managing principal of the financial regulatory consulting firm MRV Associates, said so-called "gold-plated" capital rules have not prevented American banks from outperforming their European peers in terms of stock values, returns on assets and net interest margins. She added that the difference between the regulatory proposals would not be enough to erase the advantage U.S. banks have built over other institutions.
"I don't see this as a reason for American banks to fear that somehow they're going to be overrun by British banks," Rodríguez Valladares said. "It's not like all of a sudden these banks are going to be in a position to come here and increase their presence."
Sean Campbell, chief economist at the large-bank industry group Financial Services Forum, said the disparate regimes will make it more difficult for U.S. banks to serve American customers — primarily businesses — who would like to expand into other jurisdictions.
Campbell also argued that simply because American banks have been able to thrive despite higher capital requirements does not mean they should have to.
"The notion that banks are effectively operating with one hand tied behind their back and they're still doing well, doesn't tell you that it's a good idea to be operating with one hand tied behind your back. That's an illogical argument," he said. "The question is how well would they be doing if they weren't being hamstrung by regulation that is being applied only to U.S. firms and not European ones?"
Federal Reserve Gov. Christopher Waller said in a speech that he might be willing to vote to approve the Basel III proposal if the operational risk components are sanded down.
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Operational risk
One area of the reforms where the application of national discretion is most apparent is on capital requirements applied to operational risks.
A focal point of the latest Basel standards was to standardize the treatment of operational risks, rather than the current approach which allows banks to rely on internal models. The committee established risk weights for certain exposures and a method for calculating the capital needed to offset them.
Unlike other jurisdictions, U.S. regulators incorporated this new operational risk framework in full. This equation includes aggregate risk exposures, the size of the bank and an "internal loss multiplier," which uses a bank's average annual operational losses during the trailing 10 years to amplify the amount of capital it must set aside.
In an October speech, Barr defended the approach taken by U.S. regulators.
"Research suggests that banking organizations with higher overall business volume are likely to have exposure to higher operational risk," Barr said. "Further, higher operational losses are associated with higher future operational risk exposure."
To the chagrin of bank advocates, the agencies also established a baseline — or "floor" — multiplier of 1, meaning banks with fewer past operational losses will not see their capital obligations diminished.
The UK's significantly lower proposed capital requirements are explained, in part, by its decision not to include the internal loss multiplier. In its policy statement, the Bank of England asserted that because operational losses are "infrequent but very large," they are not an accurate predictor of future losses. Instead, it subjects all banks to a multiplier of 1.
Chen Xu, a bank regulatory lawyer with Debevoise & Plimpton, said even by regulators' official estimates — which he believes understates the actual impact — the operational components of the proposal are driving "the vast majority" of capital requirement increases.
Xu said the calibration of the requirements would be felt most acutely by banks that rely more heavily on fee-based income than interest-based revenue.
"The methodology is flawed," Xu said. "It's particularly over calibrated with respect to fee- and service-related businesses, things like wealth management, retail brokerage and asset management."
Banks have been crying foul over the calibration of the proposal's capital requirements related to operational risk since this summer. But, the issue rose to prominence in the waning weeks of the year after Fed Gov. Christopher Waller — who cast one of the two dissenting votes against putting the Basel III endgame framework out for public comment — said he would consider supporting a final rule that made changes to operational requirements.
"If there's some willingness to move on operational risk and some other things, there is a possibility that this would be put forth in a revamped way that would be acceptable," Waller said during a November speaking engagement at the American Enterprise Institute.
Federal Reserve Gov. Michelle Bowman has been vocal about her opposition to the Basel III endgame proposal.
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Public discourse
A defining characteristic of the discourse around the Basel III endgame is how much of it has taken place in public.
Banks and their lobbying groups have been piloting an opposition campaign that policy experts say is "unprecedented" in the world of bank regulation. This effort has included orchestrating a demonstration on Capitol Hill and bankrolling an all-out advertising blitz to outline the potential ramifications of the proposed capital framework.
It is unclear if this public relations push has held any sway among the general public. During a live taping of the Odd Lots podcast, Barr said, to the average viewer, the ads probably sound like "the adults talking on the Peanuts." But some of the messaging has been echoed by members of Congress, including some moderate Democrats.
Critical commentary has also emerged from the regulatory agencies. FDIC Vice Chair Travis Hill and Director Jonathan McKernon, both of whom voted against the Basel III endgame proposal, have given speeches outlining their concerns about the design of the framework, the process behind it and the "gold plating" outcome.
Meanwhile, Fed Gov. Michelle Bowman — the other Fed board member to vote against the proposal — has been vocal about her concerns about the framework and the central bank's overall approach to regulation and supervision. She has outlined her position through numerous speeches and dissenting votes.
Even some of the votes in favor of issuing the proposal came with caveats. Fed Chair Jerome Powell and Vice Chair Philip Jefferson both raised issues they would like to see addressed before giving their blessing to a final rule.
"I will evaluate any future proposed final rules on their merits. My views on any proposed final Basel III endgame requirements for U.S. banking organizations will be informed by the potential impact on banking sector resiliency, financial stability and the broader economy stemming from the implementation," Jefferson said during an open meeting about the proposal in July. "I look forward to reading and digesting the comments we received from the public, which will inform my future decision on any eventual proposed final approvals."
Powell, who has the ultimate say about when the final rule will be put to a vote, has reiterated that the Board of Governors is a "consensus-driven" institution and promised to pursue "broad support" for the final package. While the rule would only need four out of seven board members to vote in support of it, it is rare for the board to see more than two dissenting votes.
How the rule is tweaked to reach that consensus will depend largely on the questions raised during the comment period and the results of the Fed's ongoing economic impact analysis. These adjustments will be made behind closed doors, but the questions that will have to be reckoned with are largely in the public record.
Historians and Fed watchers note that differing opinions are not unheard of at the central bank. Peter Conti-Brown, a financial historian and legal scholar at the University of Pennsylvania's Wharton School of Business, said the discourse around the proposed reforms have been appropriate given the subject matter.
"It's incredibly healthy," Conti-Brown said. "I probably agree with Miki Bowman 20% of the time and disagree with her 80% of the time, but 100% of the time I support having a healthy conversation about complex policy issues."
Banking trade groups have threatened to sue regulators if and when the Basel III endgame proposal is finalized over both substantive and procedural grounds.
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Legal battle looming?
For all the airtime bank capital reform has received — both in the halls of Congress and during primetime football games — some policy experts say the rhetoric around the subject has largely been pro forma.
Todd Phillips, a law professor at Georgia State University and former FDIC lawyer, said the political posturing will have little impact on the final rule. The big question, he said, is how the framework will stand up against a legal challenge, which he feels is inevitable.
"Everything is kind of set in stone up until the litigation," Phillips said. "That's where there is still some ambiguity or uncertainty about what's going to occur."
Banking trade groups have already raised procedural issues with the Basel III endgame proposal. In a joint letter sent to regulators in September, the Bank Policy Institute, American Bankers Association, Financial Services Forum, Institute of International Bankers, Securities Industry and Financial Markets Association and the U.S. Chamber of Commerce flagged several violations of "basic legal obligations."
Specifically, the groups accused regulators of drawing from non-public data sources to justify the changes they called for. The trades urged the agencies to share their documents and issue a new proposal, a step that would start the notice and commenting process over.
Since then, regulators have extended the comment period by roughly six weeks and initiated a process to collect data on how the proposed changes would impact banks. Bank advocates say regulators should have collected this data before issuing the proposal, but Phillips said that kind of analysis is not necessary under the Administrative Procedure Act.
Still, Phillips noted, if litigation is brought against the agencies, how well they followed the letter of the law will have to be determined by the courts.
"We have seen in the past that there are sometimes courts that have been willing to impose requirements after the fact that the agencies just did not realize they had to respond to, in which case there is nothing the agencies can do to prepare for situations like that," he said. "It's really unclear what's going to happen with the courts."
Others say litigation is far from guaranteed. Dennis Kelleher, head of the consumer advocacy group Better Markets, said it is common for banks to insinuate a willingness to sue their regulators over new requirements, but it rarely comes to pass.
Kelleher acknowledged that industries have had far more success in securing regulatory relief from the courts in recent years, but he said litigation in this case is not a foregone conclusion.
"I wouldn't be surprised to see lawsuits here, but the mere shouting about lawsuits is a pretty standard fare and doesn't really tell anybody anything," he said.
The Consumer Financial Protection Bureau issued a proposal to protect consumer data privacy and categorize data brokers that sell sensitive consumer data as "consumer reporting agencies" under the Fair Credit Reporting Act, a move that could garner bipartisan support.
The Delaware-based bank filed a complaint against two companies that built a WSFS logo display in downtown Philadelphia. Part of the signage eventually broke off in what the bank called an "almost-tragedy."
Federal Reserve Gov. Christopher Waller said the central bank's last framework review was too focused on the post-global financial crisis period and difficult to explain.
Federal Reserve Gov. Christopher Waller, a Trump appointee, said that while recent inflation readings are concerning, monetary policy would remain restrictive even if the central bank cuts interest rates by another quarter-point this month.
