Five things to watch for in Barr's Basel III endgame speech

September 9, 2024 1:56 PM

Federal Reserve Vice Chair for Supervision Michael Barr

After months of anticipation, the Federal Reserve's top regulator will give a comprehensive update on the central bank's regulatory capital reform proposal from last year.

Fed Vice Chair for Supervision Michael Barr is set to give a speech on the so-called Basel III endgame proposal on Tuesday morning at the Brookings Institution in Washington, D.C. He will then discuss the next steps for the interagency proposal with David Wessel, director of the think tank's Hutchins Center on Monetary and Fiscal Policy.

The reforms themselves were years in the making and stem from international standards set by the Basel Committee on Bank Supervision in 2017. Sometimes referred to as Basel IV, the accord was aimed at making the global financial system more resilient, but the standards it set out were non-binding and were left up to each participating regulatory jurisdiction to adopt.

The joint proposal from the Fed, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency in July 2023 would see aggregate capital levels increased by 16% for banks with $100 billion or more of total assets. This proposed uptick elicited fierce opposition from the industry and its allies in Congress, as well as a broad array of other trade and interest groups.

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In response to the pushback, regulators extended the deadline for commentary on the proposal, launched a data-gathering campaign to better understand the impacts of the reforms and, ultimately, pledged to make "broad and material changes" to the framework.

In July, Fed Chair Jerome Powell said his agency was prepared to move forward with a revised proposal as soon as it could reach an agreement with the FDIC and OCC on next steps.

The commitments to change have cooled the debate in and around Washington, as banks and their lobbyists wait for specifics, but the looming reforms still cast a long shadow over the industry. As Barr unveils the roadmap for the changes ahead, here are five questions that need to be answered.

Federal Reserve Board Gov. Jerome Powell

Federal Reserve Chair Jerome Powell has said a re-proposal of the Basel III endgame rule would be appropriate but noted that other agencies think the proposal could be recalibrated and finalized.

Bloomberg News

Reproposal to finalization?

One of the biggest questions on the minds of banks and lawmakers regarding the Basel III endgame is whether regulators will move to finalize a modified version of what they put forth last year or issue a brand new proposal.

Bank trade groups and several high-profile Republicans on Capitol Hill have insisted that the Fed, the FDIC and the OCC withdraw their initial proposal and put forth a new one, effectively restarting the notice-and-comment process. Proponents of the changes — including consumer advocacy groups and academics — say such a step is not legally necessary.

The choice is not binary. The agencies could move to finalize only part of what has already been presented to the public while starting the notice and comment process over for other aspects. They could also issue a supplemental proposal and only solicit input on the most significantly changed aspects.

Under the Administrative Procedure Act, the legislation that governs agency rulemaking processes, the regulators are not obligated to seek input to "minor" changes, but determining what falls under that classification is not always straightforward. A common method for evaluating such changes is the "logical outgrowth doctrine," which maintains that if a change builds on a concept put forth in the initial proposal, it can be finalized directly.

Supporters of the initial proposal say the agencies' inclusion of 174 questions and numerous alternatives provide broad latitude for logical outgrowth.

But bank groups — who have threatened litigation over the proposal — say they are entitled to a chance to weigh in on the next iteration of the proposal, given how badly they felt regulators missed their mark the first time around.

Powell was asked about whether the changes being considered could be considered logical outgrowth during an appearance in front of the Senate Banking Committee in July. The Fed chair declined to get into the specifics but indicated that the central bank might hold itself to a higher standard when determining whether to allow commentary on its changes.

"I don't want to make the legal judgment," Powell said. "I will just say, again, from my standpoint, my view and the strongly held view of some of my colleagues on the board is that it will be appropriate for us to put out the changes again for a period of comment just because it's the right thing to do."

Yet, during his testimony, Powell said the FDIC and the OCC do not necessarily share that same point of view. Look for Barr to expand on how these potential disparate views are being reconciled.

Does competition factor in?

Among the biggest concerns banks and lawmakers have about the Basel III endgame proposal, as it exists today, is that it would put U.S. banks at a competitive disadvantage on a global basis.

While the Basel Committee worked for years on a unified framework around risk capital — assigning different weights to different exposures — member institutions are given ample room to adjust the agreed-upon rules to meet their own needs. Because of this, the implementations proposed by the Bank of England and the European Central Bank would require banks to build up significantly less new capital, at 3% and 10%, respectively.

Both central banks have put their implementations on hold, citing the likely delays facing the U.S. reform package.

The impact of the U.S. proposal varies by the size and complexity of the three dozen or so institutions it touches. Banks with between $100 billion and $250 billion of assets would see their capital increased by 5%, according to the proposal, with banks with more than $250 billion that fall short of the global systemically important designation would see their capital increased by 10%. The biggest banks in the country would see a 19% increase — with the very largest banks seeing the greatest capital charge — for an overall uptick of 16%.

This so-called gold-plating by the Fed, the FDIC and the OCC has frustrated some bankers who feel the practice undermines the initial intent of the Basel Committee, which was formed to encourage other nations to align their regulatory regimes with the U.S.

"What was the goddamn point of Basel in the first place?" JPMorgan CEO Jamie Dimon said during an on-stage appearance in September 2023.

The disparity between the U.S. proposal and those put forth by other leading banking jurisdictions caused some in Congress to question the benefit of American participation in international standard-setting groups.

But regulatory officials say the U.S. has a long history of going above and beyond international minimum standards and, thus far, it has not prevented American banks from being globally competitive. Michael Gibson, the Fed's director of supervision and regulation, said the approach has served the banking system well.

"I would say that the fact that we've had strong regulatory standards in the U.S. has been a source of strength for our banking system and our economy," Gibson said during testimony in front of the House Financial Services Committee in March. "I can't point to a particular bank that didn't fail because we did this … but overall, I think we have a strong system."

What happens to operational risk?

One area in which the U.S. proposal differs significantly from other jurisdictions is the treatment of operational risks, which are more closely related to business practices than pure financial management.

Examples of operational risk include litigation, cybercrime, fraud and malpractice by bank employees, or threats to business continuity from natural disasters like floods and hurricanes. Unlike the other three categories of risk in the proposal — credit, trading and derivatives contracts, also known as credit valuation adjustment — these factors vary widely from firm to firm and can be hard to anticipate and quantify. Regulators have historically relied upon banks' own calculations for gauging these types of risks, but the proposal calls for replacing these internal models with standardized ones.

Bankers have criticized the proposal's treatment of operational risk as punishing banks for creating fee-based businesses, which are more operationally intensive but less reliant on net interest margins for profit. And, unlike other jurisdictions, the U.S. proposal would multiply certain risk capital weights based on past operational losses. The proposal argues that this approach accounts for persistent deficiencies, while banks say it punishes them twice for incidents that are unlikely to be repeated.

Barr has argued that the current system for addressing operational risks needs to be more consistent and transparent, but not all policymakers agree with that view. Fed Gov. Christopher Waller questioned the need for a standalone operational risk charge, noting that capital earmarked for market and credit risks could be tapped for idiosyncratic events — such as lawsuits, cyber attacks or fraud.

Powell has said the Fed is not targeting a unanimous vote from its seven board members on the proposal, but he would like it to have "broad" support. Reaching that consensus will likely mean changes to the proposal's approach to operational risk.

What about mortgages?

Banks and housing advocates alike have raised concerns about the mortgage-related aspects of the Basel III capital proposal.

Bank trade group the Bank Policy Institute argues that the proposed risk weights for residential mortgages are excessive and not reflective of actual historical risk in the U.S. mortgage market.

Under the proposal, risk weights for balance-sheet mortgages would increase from the current 50% to as high as 90%, and additional charges for operational risk and stress testing could raise the total risk weight to 115%. The Bank Policy Institute says the proposal would make the U.S. unique, as other countries allow banks to use internal loss data to assign risk weights, while the U.S. proposal mandates a uniform government formula.

Banks argue that this approach would disincentivize them from originating mortgages, particularly for sale to government-sponsored enterprises, which in turn would harm low- and moderate-income households that rely on banks for mortgage services. The proposal could also make it more difficult for minority homebuyers to access affordable mortgages, as the additional charges would drive up mortgage rates, further reducing affordability.

The National Housing Conference and other housing advocacy organizations argued in a comment letter on the proposal that the rule's mortgage provisions would increase capital requirements disproportionately, especially for high loan-to-value mortgages. They warn that this disincentivizes banks to make such loans, which could negatively affect first-time, low- and moderate-income, and minority homebuyers, who often lack generational wealth and rely on affordable mortgage options.

Will banks be satisfied?

The industry's lobbying efforts against the proposal have included public relations campaigns and media buys — including ads on Sunday Night Football — aimed at persuading regulators to withdraw the proposal. BPI President Greg Baer has said regulators over-calibrated the proposal without providing sufficient evidence justifying the stricter standards.

"When you actually look at the loss data — to the extent we have it — it seems to argue for considerably lower risk weights than what's been proposed, and I think that's across all the major risks, whether that's credit risk, operational risk, market risk," he said in a podcast interview. "There are a lot of questions that were unanswered in the proposal, there was a lot of data that wasn't supplied, so we'd like them to go back to work and produce something that's more grounded in experience and analysis."

He has said it's possible that the agencies could soften the proposal enough to satisfy banks, but that they are prepared to sue if not. Powell has expressed sympathy to these critiques.

Bank trade groups have hired Eugene Scalia, a corporate attorney and former labor secretary under President Donald Trump, to potentially challenge the Basel III endgame capital requirements. Industry groups have said they are ready to sue unless banks change the plan substantially.

Jaret Seiberg of TD Cowen argues Barr's speech may leave some questions unanswered, like whether the Fed's Republican board members will back the reformed proposal.

"There is a possibility of GOP support at the Fed, though less likely at the FDIC," he wrote in a note Monday. "The more GOP support there is at the agencies and on Capital Hill, then the more the new proposal is protected from election risk."

Former regulator Mark Calabria of the Cato Institute has noted that — unlike bank regulation proposed after the 2008 financial crisis — regulators have less cover to enact sweeping new rules. The lack of public attention on and concern for banking reforms today strengthens the banks' position to oppose stricter regulations.

"There is a change in dynamic and so the industry has a stronger hand than they had in 2010, because, again, the public is less concerned about banking issues right now," he said in a podcast interview with American Banker. "Where I would sit is to say, can we come up with a regulatory system that has more capital, but lowers some of the compliance costs and tries to be simpler in a way that perhaps, you know, at least some of the industry can accept."