bankregblog.substack.com Overview of 2023 U.S. Capital Rules Proposals July 28, 2023 bankregblog.substack.com Introduction 2 bankregblog.substack.com Introduction 3 • After the 2008 financial crisis the Basel Committee on Banking Supervision made revisions to the capital standards for internationally active banks. • These revised standards, completed at the international level in 2010 (though later revised a bit), were referred to as Basel III and were implemented in the United States through rules finalized in 2013. • The Basel Committee did not believe its work to update the Basel capital standards was fully completed with the changes made immediately after the 2008 financial crisis and so throughout the 2010s sought to make further improvements to the overall Basel framework. • The Committee ultimately agreed on newly updated rules in 2017 (although again they were later further tweaked). These further changes have variously been referred to as Basel IV, Basel 3.1, the finalization of the post-crisis reforms, or the Basel Endgame. bankregblog.substack.com Introduction 4 • Adoption of the final Basel standards in the United States was slowed by the COVID-19 pandemic and other factors, including a longer-than-expected vacancy at the Federal Reserve Board in the role of Vice Chair for Supervision. • A new Vice Chair for Supervision, Michael Barr, was finally confirmed in July 2022. • Soon after assuming the role, VCS Barr announced that, in addition to the work that was already in progress to put together a Basel Endgame proposal, he also intended to conduct a holistic review of the U.S. capital regime. • “We are looking holistically at our capital tools to understand how they are supporting the resilience of the financial system, individually and in combination. When calibrating requirements, we will work to minimize unintended consequences, limit opportunities for gaming, and avoid excess compliance costs that do not result in risk reduction. Taking a holistic view will help us consider adjustments, if any, to the supplementary leverage ratio, countercyclical capital buffer, and stress testing. Within this context, I am also committed to implementing enhanced regulatory capital requirements that align with the final set of ‘Basel III’ standards or the so-called the ‘Basel endgame.’” bankregblog.substack.com Introduction 5 • On July 27, 2023, the U.S. federal banking regulators released proposed revisions to the U.S. capital rules (Proposal). * • The Proposal includes a faithful(ish) implementation of the finalized Basel standards, as well as other changes to the U.S. capital framework attributed to findings of the holistic review undertaken by Vice Chair for Supervision Barr. • Links to materials, including staff memos, fact sheets, overviews, supporting and dissenting statements, etc.: • Board • FDIC • OCC • The comment period on the Proposal is currently scheduled to close on November 30, 2023. * Technically the Proposal is two separate releases: (i) an interagency proposal from the Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency and (ii) a standalone proposal from the Board to revise the surcharge framework applicable to U.S. GSIBs. (Because this surcharge applies only at the holding company level, the Board is the only agency required to issue rules to implement it.) bankregblog.substack.com Big Picture Observations 6 bankregblog.substack.com Big Picture Observations 7 1. Capital Requirements are Going Up • The Proposal’s move to materially increase capital requirements has been foreshadowed for months now but was not always necessarily the expectation. • At one point the banking sector was hopeful that the Proposal would, on the whole, be capital neutral. See, e.g., this Bloomberg story from 2017 saying that large banks had emerged as winners from the final Basel standards. • In a letter to Chair Powell earlier this month, trade groups highlighted comments from international regulators that the trade groups contend also stand for the proposition that, overall, the goal of the Basel III finalization was something close to capital neutrality. • See also these 2019 comments from the Federal Reserve Board’s General Counsel:* “we’re still kind of in the early days of working interagency, FDIC, FED, OCC on figuring out how to implement the Basel three end game. We at the Fed at least are quite committed to doing it in a capital neutral way . And to also do it in a very thoughtful, comprehensive way, where we don’t kind of finalize various pieces without thinking about the whole, and its accurate impact on the banking system and individual banks. Our capital neutrality objective by the way doesn’t mean it’s going to be capital neutral for every single bank that might be subject to the new rules. It’s more of an aggregate assessment. But we are thinking through quite carefully every piece of that framework, FRTB, but also the credit risk and operational risk bits. ...[W]e’re going to try to do it in a very thoughtful way that I think improves the regulatory capital framework for internationally active banks in the U.S., but doesn’t do it in a way that does any kind of a material raise or lowering of the capital calibration .” *The transcript linked above erroneously attributes this statement to the FDIC’s then-General Counsel. bankregblog.substack.com Big Picture Observations 8 1. Capital Requirements are Going Up • In any case, the agencies ultimately opted for a different approach, with these estimated effects: * • In the aggregate, RWAs are estimated to increase at the holding company level by 20 percent and at the depository institution level by 9 percent. • Increases would not be evenly distributed. RWAs of U.S. GSIB holding companies would increase by 25 percent, ** while RWAs of U.S. regional bank holding companies with $100B or more in total assets ** would increase by 6 percent. U.S. IHCs of foreign banking organizations would also see an RWA increase of approximately 25 percent. • Binding CET 1 capital requirements are estimated to increase by around 16 percent. • Again the effects of this would vary across firms: binding CET 1 capital requirements for U.S. GSIBs would increase by an estimated 19 percent, binding CET 1 capital requirements for U.S. regional bank holding companies with $100B or more in total assets would increase by an estimated 6 percent, and binding CET 1 capital requirements for U.S. IHCs of foreign banking organizations would increase by an estimated 14 percent. • Average TLAC requirements for U.S. GSIBs are estimated to increase by 15.2 percent as a result of the proposed RWA changes. • As a general matter the biggest driver of these increases are changes to market risk capital requirements, but operational risk RWAs may also be material for some firms. * See p. 493 of the Proposal for a discussion of “several caveats” that accompany these estimates. ** The shorthand used on this slide is a little loose. The Proposal discusses the effects on Category I and Category II firms (so, yes, the U.S. GSIBs but also Northern Trust to the extent that changes the math) and separately on Category III and Category IV firms (most of which fit the bill as regional banks, although there are a few with different business models.) bankregblog.substack.com Big Picture Observations 9 2. Some Firms May Need to Raise or Retain Capital • Using year-end 2021 data the Proposal estimates that a few large firms would have less capital than what would be required. Specifically: • Five holding companies had less CET 1 capital than the Proposal estimates would be required, and would need to increase capital ratios by between 16 and 105 basis points relative to RWAs prior to the proposed changes. • The Proposal just says five “Category I or II” firms and does not name individual firms. • All other holding companies, and every depository institution, would have had sufficient levels of CET 1 capital. • Three U.S. GSIBs would have had a “moderate shortfall” in required TLAC. • Again the Proposal does not identify any firm by name. • The Proposal is fairly relaxed about these shortfalls, noting that “the largest U.S. bank holding companies annually earned an average of 180 basis points of capital ratio between 2015 and 2022.” • One key question is the extent to which banking organizations will be willing retain some of that capital as opposed to shifting their activities away from those activities that generate increased RWAs. bankregblog.substack.com Big Picture Observations 10 3. Not So Bespoke • In October 2019 the Board adopted rules to tailor the application of certain enhanced prudential standards, including certain capital-related requirements. The tailoring framework adopted by the Board divided firms into categories based on their size and risk profiles. • As shown in the below graphic from 2019, there are currently meaningful differences in capital requirements depending on category. bankregblog.substack.com Big Picture Observations 11 3. Not So Bespoke • The Proposal would not change any of the tailoring Categories. A firm with $100 billion in assets is all else equal still going to be in a lower Category than a firm with $400 billion in assets, and a firm with $400 billion in assets is in turn all else equal still going to be in a lower Category than a firm with $1 trillion in assets. • What the Proposal would do, however, is meaningfully reduce the differences in requirements that apply across Categories. In particular, Category III and Category IV would be come subject to a number of new requirements that currently apply only to U.S. GSIBs (and one Category II firm). Notable changes here include, among others: • Elimination of AOCI opt-out (subject to transition provisions) • Same required deductions from capital as Category I and Category II firms • Dual stack capital requirement • Operational risk RWAs • Required to use SA-CCR for calculating exposure amount of derivative contract • Market risk RWAs (to the extent not already subject) • CVA risk RWAs • Category IV firms subject to SLR and CCyB • Statements from the federal banking regulators suggest that large banks should expect similar broadening in the application of liquidity requirements through a future rulemaking. bankregblog.substack.com Big Picture Observations 12 4. Is Tailoring Over? • Under the Dodd-Frank Act as amended by the Economic Growth, Regulatory Relief and Consumer Protection Act (EGRRCPA), the Federal Reserve Board “shall” differentiate between companies on an individual basis when adopting enhanced prudential standards. • As EGRRCPA supporters argued after the failure of Silicon Valley Bank, this does not mean that the Board is prohibited from imposing enhanced prudential standards on firms with > $100B in total assets. But it does mean that the Board is subject to potential constraints when doing so. • If the Proposal were to be adopted, there would still be a degree of differentiation between firms, in the sense that U.S. GSIBs remain subject to additional requirements (e.g., GSIB surcharge, eSLR, TLAC), but the differences between Category II, III and IV firms would be relatively minimal. • In a likely preview of comments to come, dissenters on both the Federal Reserve Board of Governors and the FDIC board of directors all highlighted this point: • Governor Bowman: “I am also concerned that today's proposal moves one step closer to eliminating the tailoring required by S. 2155 from the prudential capital framework.” • Governor Waller: “I am concerned that we are headed down a road where we would be no longer in compliance with section 165 of the Dodd-Frank Act, as amended by the Economic Growth, Regulatory Relief, and Consumer Protection Act, which mandates tailoring for firms above $100 billion in assets and provides that firms with between $100 billion and $250 billion in assets are not subject to enhanced prudential standards unless a standard is affirmatively applied to such firms based on specific factors set out by Congress. It is unclear to me whether this proposal meets that statutory bar.” • FDIC Vice Chairman Hill: “For purposes of the capital rules, the proposal effectively collapses Categories II, III, and IV into one category. The proposal undoes almost all of the tailoring of the capital framework for large banks, and is a repudiation of the intent and spirit of S. 2155.” • FDIC Director McKernan: “What requirements or restrictions on each agency’s authorities are implicated by the proposal? Does the proposal tailor or otherwise differentiate among banking organizations to the extent required by law?” • In 2018 Michael Barr warned that the “shall” tailor language in the EGRRCPA “hand[ed] large banks a litigation tool against stricter standards.” How powerful a tool that language really is may be put to the test. bankregblog.substack.com Big Picture Observations 13 5. What Does It Mean for M&A? • Assuming the federal banking regulators are receptive to bank M&A (still an open question), holding all else equal the Proposal would seem to encourage M&A between firms with more than $100 billion in total assets, given that the consequences of being, say, a Category II firm compared to a Category IV firm no longer would be as stark, at least when it comes to capital. • On the other hand, firms that are currently below $100 billion in total assets would under the Proposal need to think even harder about crossing that threshold (either organically or through M&A), given that the consequences of doing so would be to subject the firm to nearly the full suite of capital requirements, other than those that apply to U.S. GSIBs. bankregblog.substack.com Big Picture Observations 14 6. Agencies Attentive to Competitive Equity Considerations, But... • One of several themes in criticisms made by banks prior to the unveiling of the Proposal is the importance of ensuring competitive equity between U.S. banks and their non-U.S. peers, or between U.S. banks and their non-bank competitors. • The Proposal couches several of its decisions in competitive equity terms, but not in the way that large U.S. banks will like. For example: • Rather than following the updated Basel approach to risk-weights for mortgages and retail credit exposures, the Proposal would adopt comparatively higher risk weights. The agencies say explicitly say that this is being done to “mitigate potential competitive effects” of the Proposal on smaller banks. • “Without the adjustment relative to Basel III risk weights in this proposal, marginal funding costs on residential real estate and retail credit exposures for many large banking organizations could have been substantially lower than for smaller organizations not subject to the proposal.” • The agencies are comfortable subjecting large U.S. banks to significant increases in market risk RWA requirements because this “would help promote competitive equity among U.S. banking organizations and their foreign peers and competitors, and reduce opportunities for regulatory arbitrage across jurisdictions.” • See also Vice Chair for Supervision Barr’s remarks a few weeks ago, in which he argued that the current GSIB surcharge “promote[s] competitive opportunities for large banks that are not-G-SIBs in order to maintain the diversity of our banking system.” bankregblog.substack.com Big Picture Observations 15 7. A Potential Setback for Non-U.S. Banks With Significant U.S. Operations • As discussed on the previous slide, U.S. GSIBs sometimes make competitive equity arguments and generally believe that they have it worse compared to their European peers. • European banks, naturally, disagree. See for example these comments from Deutsche Bank’s CFO on their earnings call a few days ago. • “On U.S. Basel III final framework, obviously, very curious to see what's in it. I don't think it really impacts us in a meaningful way. In terms of our business operations, potentially competitive positioning, given that, in our view, European banks have been at a capital disadvantage for some time.” • Maybe that is so, but one unexpected element of the Proposal released yesterday – to me at least – was the way it would increase the regulatory requirements that apply to foreign banking organizations by changing the way a key risk metric is calculated, such that many foreign firms would move to a more stringent Category under the U.S. tailoring rules. • This is discussed in detail later starting on slide 72. bankregblog.substack.com Big Picture Observations 16 8. Chair Powell Open to Changes • Chair Powell voted to support the issuance of the Proposal for comment, continuing his track record of deferring to, and supporting proposals made by, the Vice Chair for Supervision. • With Chair Powell’s vote, the Board vote was 4-2 in favor. • Chair Powell also signaled, however, that he is certainly open to “potential modifications” and called out three areas on which he is “particularly interested in reviewing public feedback and analysis.” • “The first is to assess the calibration of these proposed capital increases, both overall and for specific areas such as capital markets activities and operational risk.” • “Second, the proposal exceeds what is required by the Basel agreement, and exceeds as well what we know of plans for implementation by other large jurisdictions. ... We will need to ensure that the consistency and anti-arbitrage benefits of the new standardized approaches outweigh the costs of treating the risks of some quite different business activities as identical, which could reduce risk capture and discourage less risky activities.” • “[R]ecent events have demonstrated the need to strengthen supervision and regulation for firms with assets between $100 billion and $250 billion. Here too, however, we need to strike the right balance. Regulation and supervision should reflect the size and risks of individual institutions.” • Perhaps more unexpectedly, Governor Jefferson also expressed concerns about certain aspects of the Proposal while supporting its issuance for public comment. bankregblog.substack.com Additional Discussion 17 bankregblog.substack.com Additional Discussion 18 Contents • Capital Buffers • Capital Conservation Buffer • Stress Capital Buffer • Countercyclical Capital Buffer • GSIB Surcharge • Leverage Capital Requirements • Leverage Ratio • Supplementary Leverage Ratio • Enhanced Supplementary Leverage Ratio • TLAC and Long-Term Debt Requirement • Other Items • Changes to Cross-Jurisdictional Activity Calculation • Consideration of Stress Testing Changes • Pillar 2 • Crypto • Tailoring Categories • Minimum Risk-Based Capital Ratios • Definition of Capital and Minimum-Risk Based Capital Ratios • Accumulated Other Comprehensive Income • Deductions From Capital • RWAs for Credit Risk • RWAs for Market Risk • RWAs for Operational Risk • SA-CCR • CVA Risk RWAs • Equity Exposures • Collins Amendment; Output Floors • Transition Provisions bankregblog.substack.com Tailoring Categories 19 bankregblog.substack.com Tailoring Categories 20 Current Rules • Under changes made by the federal banking regulators after the enactment of the EGRRCPA, U.S. capital, liquidity and other prudential rules divide firms into categories, with the stringency of requirements generally increasing as a firm moves into the next category. • Under current rules, the thresholds are as follows. • Category I = U.S. GSIBs • Category II = a firm that is not a U.S. GSIB with >$700B in total assets or >$75B in cross-jurisdictional exposure • Category III = a firm that is not in Category I or Category II with >$250B in total assets or >$75B in non-bank assets, off-balance sheet exposure, or weighted short-term wholesale funding • Category IV = a firm that is not in Category I, Category II or Category III with >$100B in total assets. • Other Firms = all other firms with <$100B in total assets • For foreign banking organizations some standards apply based on the Category of the firm’s U.S. intermediate holding company (IHC) standing alone, while others apply based on the Category of the firm’s combined U.S. operations (that is, its U.S. IHC plus its U.S. branches and agencies)