BankThink

Gaming out regulators' next moves on Basel

Michael Barr
Michael Barr, vice chair for supervision at the Federal Reserve, is at the center of negotiations at the Federal Reserve Board about whether the interagency Basel III endgame capital rules should be finalized with changes or withdrawn and reintroduced.
Bloomberg News

WASHINGTON — A "fork" in chess is a brilliant little tactic whereby a single piece is attacking two opposing pieces at once, forcing one's opponent to choose between losing one piece or the other. The pressure is doubly severe when the inferior piece being attacked also occupies the superior strategic position; thus a fork, well executed, puts one's opponent in an inherent posture of bargaining for the better of two bad outcomes. 

Federal banking regulators in general, and the Federal Reserve in particular, have played themselves into a similar posture with respect to their Basel III endgame rulemaking process. There is more than one way forward, but choosing the best one entails the kind of careful weighing of options, advantage and countermoves that could make any grandmaster sweat.

To briefly recap, the Basel III endgame (née Basel IV) rules were finalized despite considerable debate and delay almost a decade ago and then remained untouched until the confirmation of Michael Barr as vice chair of supervision at the Fed, soon after which occasion Barr made known that the Basel rules would be on the near-term agenda and would entail higher rather than lower or neutral topline capital standards for banks.

Those standards were presumably being hashed out in the background over the next many months until the abrupt failures of Silicon Valley Bank and Signature Bank in March of 2023 and the brokered failure of First Republic in May. The Basel rules were then seemingly fast-tracked and framed as at least a partial policy response to those failures and were proposed to mixed reviews less than three months after First Republic's failure. Between uncommonly intense opposition from the banking industry and Republicans, skepticism from moderate Democrats and an unclear majority on the Fed Board for passage, it seems clear that the sharper edges of the final rule will have to be sanded down considerably from what was initially proposed.

The question, then, is whether regulators are able to reengineer the proposal such that a critical mass of approval can be attained and the rule can be finalized, or whether the entire enterprise — and the all-important regulatory clock — will have to be restarted. Nominally, the administration would prefer to finalize the rule so as to avoid the possibility of it either being struck down via Congressional Review Act resolution or placed back in regulatory cold storage if the administration changes after November. Conversely, banks and Republicans would prefer it to be re-proposed to encourage such an outcome.

But there are long-term risks to both sides of this policy were they to prevail in achieving their preferred short-term outcome. Let's say that opponents to the rule as written on the Fed board insist on re-proposal rather than finalization; this would delay the rule, but not kill it entirely. The U.S. would remain a signatory to the Basel accords, and some future willing administration would likely pick up where this one leaves off — if, indeed, there is a change in administration at all. 

Likewise, plowing ahead with the rule with a bare majority would inevitably lead to continued backlash and perhaps contribute to a perception of the Fed as out of touch, weakening the institution at a moment when it has a realistic chance of generating popular goodwill if growth remains high and a soft landing is ultimately achieved. There is, in other words, good reason to keep this affair from getting any messier than it absolutely has to be.

A more prudent approach — at least as it seems to me, looking from the outside in — would be to calibrate the proposed rule such that its interlocking parts fit more comfortably together and amongst the rest of the bank capital apparatus. If that results in a more modest increase in capital — say, somewhere between what has been finalized in the U.K. and EU — that's an outcome that a sizable portion of the banking community would probably be able to live with. That may or may not stop litigation, but it would certainly make banks think twice about undertaking the time and expense of fighting the rule in court. 

Taking that road accomplishes a few things. For one, it would require large firms to account for unrealized losses in their available-for-sale securities, a relatively noncontroversial aspect of the rule in light of last year's bank failures. It would also put Basel III in the rearview mirror, completing an early agenda item for the administration. And if the ultimate goal of regulators is to raise capital requirements for the largest banks — an idea that has been around for a long time — it would allow regulators to live to fight that fight another day. 

Whether such a deal is feasible depends on the state of negotiations at the Fed, but I suspect that it could be had. Fed Chair Jerome Powell said last week that re-proposal is "plausible" but not necessarily inevitable. What would make it inevitable is if the sticking points are about fundamental problems in the models and assumptions themselves — if a satisfactory final rule would require the creation of new frameworks out of whole cloth. But if it is a matter of magnitude rather than method, both sides would benefit from getting to yes. Failing to do so, by contrast, could result in a checkmate. 

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