Mitigate Potential Unnecessary Capital Requirement Increases
This is the third post in a series preparing readers to evaluate a proposal by U.S. regulators to implement the Basel Finalization agreement, expected in the first half of 2023. We focus here on potential modifications to the Basel package or other elements of the U.S. capital framework to improve the risk sensitivity and reduce the procyclicality of the capital framework in order to prevent banks from needing to restrict lending activity during an economic downturn. The first post in this series discussed the background and principles of the Basel framework and its development, leading to the 2017 revisions. The second covered potential options for the structure and scope of U.S. implementation.
Capital requirements in the United States have risen significantly since the global financial crisis in 2007-09 – first, from the introduction of post-crisis reforms both in terms of higher quality of capital and increases in capital requirements and risk-weighted assets. More recently, capital requirements for large banks have increased further due to increased Global Systemically Important Banks (GSIB) surcharges on the largest banks resulting mainly from economic growth and inflation. Furthermore, the expansion of banks’ balance sheets caused by the exceptional monetary and fiscal measures taken to mitigate the economic impact of the COVID-19 pandemic has added pressure to leverage ratios and contributed to the increase in banks’ stress capital buffers.[1]
In his departing remarks in December 2021, former Federal Reserve Board Vice Chair for Supervision Randy Quarles indicated that U.S. implementation of Basel Finalization revisions could increase capital requirements by as much as 20 percent for the largest U.S. firms, while also noting the overall level of capital in the banking system is “more than ample”. Much of the increase would derive from incorporating “operational risk” into the standardized approach for calculating risk-weighted assets, as discussed in greater detail in a prior post. The U.S. capital framework has not previously included this type of risk in its standardized approach for calculating risk-weighted assets. The standardized approach for operational risk also imposes higher capital charges for banks that rely more heavily on noninterest income relative to net interest income (e.g., banks with proportionally higher capital markets activities).
Another component of the Basel Finalization package that would significantly affect bank capital requirements is the “Fundamental Review of the Trading Book” (FRTB), an international standard finalized in 2019, which fundamentally alters the minimum capital requirements for market risk, specifically those that apply to banks’ trading activities. These FRTB changes are expected to have a significant impact on banks’ minimum capital requirements for market risk, as well as on their risk management and infrastructure.[2] Compared with the existing market risk standard, FRTB is designed to capture tail risk more effectively in stressed conditions, placing stricter restrictions on the use of banks’ own internal models for measuring market risk than the current rules. However, U.S. regulators have already adopted a separate capital charge explicitly designed to capture tail risk via the global market shock (GMS) in the Dodd-Frank Act Stress Tests (DFAST).
The adoption of FRTB and other elements of the Basel Finalization package will significantly affect U.S. capital markets. Past changes, such as the introduction of the GSIB surcharge and the inclusion of the GMS in stress tests, have already incentivized banks to lower their inventory levels for market making activities, hindering their ability to serve customers. Unlike other jurisdictions, the U.S. relies heavily on capital markets for corporate and household funding (70% vs 30% from bank loans), making it crucial for regulators to avoid overregulation and allow banks to maintain efficient market making and intermediation.
A key factor in determining the overall level of capital requirements in the U.S. will now be whether and how U.S. regulators balance any increases in capital requirements resulting from the implementation of Basel Finalization and FRTB changes by adjusting other elements of the U.S. capital framework, such as the GSIB surcharge methodology, stress testing practices or other capital requirements. This will be important in ensuring that the U.S. capital framework remains robust and effective in protecting the financial system.[3]
In various ways, U.S. regulators could use the discretion allowed within the Basel standard to implement the Basel Finalization package in a way that reflects the existing U.S. standards and national market structure, and adjust other elements of the U.S. capital framework. These changes could offset unnecessary increases in capital requirements without compromising the risk sensitivity of the U.S. regime or the stability of the financial system. Specifically, we have focused on six important options that would have a meaningful effect on bank capital requirements. Of course, other potential changes could be made beyond the six discussed here, particularly when it comes to changes to risk-weighted assets.
Possible Adjustments to Risk-Weighted Assets
1. Credit Risk: Remove the Securities Listing Requirement for Corporate Exposures
Under the Basel Finalization’s standardized approach to credit risk, in jurisdictions such as the United States where external credit ratings cannot be used for regulatory capital purposes, a corporate entity qualifies for the lower investment grade risk weight of 65 percent (as opposed to 100 percent for non-investment grade entities) if the entity (or its parent company) has securities outstanding on a recognized securities exchange. In the United States, this requirement would mean that, to qualify as investment grade, a company would be subject to a host of SEC-related regulatory and disclosure requirements applicable to public companies.
In addition, listing standards often include factors unrelated to credit quality (such as governance requirements intended to protect investors). In practice, few firms that borrow from U.S. banks would meet the securities listing requirement, regardless of their creditworthiness. Generally, only the largest firms meet this standard.[4] Because this requirement would not be indicative of the level of credit risk associated with an exposure, U.S. regulators may consider removing it to avoid unnecessarily increasing borrowing costs for many highly creditworthy corporate borrowers (and essentially all small business borrowers).
2. Operational Risk: Set the Internal Loss Multiplier to 1 and Adjust the Services Component
To the extent the United States implements the Basel standardized approach for operational risk (SA-OPE), to limit the amount it increases U.S. firms’ capital requirements, U.S. regulators could take advantage of the Basel Finalization standard’s option not to increase the otherwise-applicable operational risk charge due to historical losses by setting the Internal Loss Multiplier (ILM) component of the OPE to 1.[5] In addition, past BPI analysis has shown that the OPE’s calculation of operational risk overstates operational risk losses (particularly for banks with proportionately higher fee revenue and expenses) and therefore leads to inflated operational risk capital charges. To avoid such an overstatement, U.S. regulators could adjust the OPE by placing a cap on the amount that historical income generated from services (which includes fee revenue) could increase the overall operational risk charge.
3. Credit Risk: Remove the Minimum Haircut Floors for Securities Financing Transactions (SFTs)
The Basel Finalization revisions establish minimum economic haircuts applied to collateral for SFTs with non-bank counterparties (e.g., pension funds, mutual funds, etc.). The purpose of these haircuts is effectively to reduce bank financing of non-bank counterparties. If an SFT is collateralized below a minimum economic haircut, the entire transaction must be treated as an unsecured loan with no recognition of collateral. Several jurisdictions that have already released proposals implementing the Basel Finalization package have not included the minimum haircut floors for SFTs. U.S. regulators should follow suit since the minimum haircut floors, as designed, would unduly impact transactions with end-users. For example, reverse repurchase agreements are not financing transactions but would typically fall below the floor, thereby making these transactions with non-bank counterparties completely uneconomical.
Possible Adjustments to Capital Buffers
4. Address Double-Counting of Market Risk and Operational Risk in the Basel Finalization Package and the Supervisory Stress Tests[6]
Banks are currently required to hold additional capital via the stress capital buffer to cover risks that are less well measured under the current standardized approach for risk-weighted assets. With the Basel Finalization revisions set to enhance the measurement of operational and market risks, adjustments to the stress capital buffer are necessary to prevent double counting these risks.
The implementation of FRTB in the U.S. faces specific challenges, as the existing capital framework already includes a capital charge for market tail risk through the GMS component of DFAST. In fact, losses resulting from GMS often comprise a significant portion of banks’ required SCBs for those banks subject to the GMS. Since both GMS and FRTB aim to capture tail risk, implementing FRTB without adjusting either the FRTB standard or the GMS would require banks to overcapitalize for this risk. Our previous blog post delves into this issue and presents potential solutions.
In addition, the supervisory stress tests already incorporate a component related to a bank’s ability to withstand operational risk losses. As a result, if the SA-OPE is incorporated into the risk-weighted assets used to evaluate compliance with the SCB, there could be a resulting double count of capital required for operational risk. To resolve this, the Federal Reserve could also adjust the SA-OPE as discussed above, or re-evaluate the operational risk components in its supervisory stress tests for firms subject to the new operational risk framework.
5. Modify the U.S.-Specific GSIB Methodology
As noted in our introductory post, the United States requires each Global Systemically Important Bank (GSIB) to calculate the amount of its GSIB surcharge capital buffer requirement as the larger of the internationally agreed method (called “Method 1” in the United States) and a U.S.-specific method (“Method 2”), which generally results in higher GSIB surcharges. As a result, the binding capital requirements applicable to U.S. GSIBs are already higher than what they would be under an unmodified implementation of the Basel standards. Currently, the average GSIB capital surcharge under the United States’ Method 2 is 2.7 percent, 1 percentage point higher than the average surcharge calculated under Method 1.
Aside from eliminating Method 2 altogether, U.S. regulators have several ways to adjust Method 2 scores to align U.S. GSIB surcharges more closely with those of non-U.S. GSIBs. Such adjustments could partially offset any increase in overall capital requirements brought about by the Basel Finalization package. These changes would have the added benefit of removing one of the structural disadvantages for U.S. GSIBs compared with their international counterparts. Possibilities include adjusting, and thereafter indexing, the methodology to account for economic growth and inflation; narrowing the GSIB surcharge bands; and resetting the weight of Method 2’s short-term wholesale funding component back to 20 percent. For instance, the Federal Reserve, in its publication of the final rule for the GSIB surcharge, stated that it would “periodically reevaluate the framework to prevent factors unrelated to systemic risk from affecting a bank holding company’s systemic indicator scores.” However, no such reevaluation has yet taken place.
6. Address the Effects of Reserve Balances and U.S. Treasuries on Risk-Based Requirements
As we discussed in a previous post, although reserve balances are an asset with a zero risk weight, because of the way that buffer requirements are calculated, increases in bank size from risk-free assets (including reserves) still affect risk-based requirements for two primary reasons. First, they increase the size and short-term wholesale funding components of the GSIB surcharge score, and therefore increase GSIB surcharges. Second, they are an important determinant of expenses and operational risk losses in the supervisory stress tests, and therefore increase firms’ SCBs. Therefore, excluding cash balances and U.S. Treasuries from balance sheet assets to normalize the subcomponents of noninterest expense and other PPNR subcomponents currently normalized by total assets would largely remove QE’s effect on PPNR projections in the stress tests.
[1] BPI has previously shown the effect of balance sheet growth on stress test projections. DFAST 2022: Volatility, Capital Increases, and the Implications for the U.S Economy (June 27, 2022), available at https://bpi.com/dfast-2022-volatility-capital-increases-and-the-implications-for-the-u-s-economy/.
[2] According to a recent report by the Basel Committee, market risk RWA would increase up to 90 percent under the FRTB relative to current market risk requirements.
[3] For example, BPI has previously discussed how FRTB implementation could require firms to overcapitalize for market risk. On the Overcapitalization for Market Risk Under the U.S. Regulatory Framework (April 21, 2022), available at https://bpi.com/on-the-overcapitalization-for-market-risk-under-the-u-s-regulatory-framework/.
[4] A 2021 study using Federal Reserve data shows that banks subject to the stress tests lend to 155,589 unique U.S. corporations, of which 153,000 are private. Therefore, the large majority of U.S. corporations do not meet the securities listing requirement. See Caglio, Cecilia; Mathew Darst; and Sebnem Kalemli-Ozcan; “Risk-Taking and Monetary Policy Transmission: Evidence from Loans to SMEs and Large Firms,” National Bureau of Economic Research, WP #28685 (April 2021), available at https://conference.nber.org/conf_papers/f159755.pdf#page=14.
[5] The Basel III endgame standard allows, but does not require, national regulators to increase a firm’s RWA for operational risk by multiplying the RWA amount by a scaling factor (the ILM) that depends on each bank’s average historical losses over the previous 10 years. Banks with higher historical losses over this period would therefore face higher operational risk RWAs, even if the firm had discontinued businesses that contributed to the losses, improved its operational risk management systems and processes, or otherwise reduced its operational risk exposure.
[6] The scope of overlap is not limited to market and operational risk. For example, securitizations could take a capital charge across stress testing and the RWA frameworks that is greater than its max loss, suggesting that there is overlap (or a double counting of risks) between the two frameworks.
