Problems with the Basel Proposal
Yesterday, BPI filed the first of two comment letters on the banking agencies’ Basel proposal. This first letter focused on significant legal and substantive problems; a second letter will describe in detail what a truly risk-based assessment of credit, market, operational and CVA should look like. As our first letter explains, the proposal assigns risk weights to bank assets and exposures generally based on no data or analysis; ignores voluminous data on loss experience held by the agencies and the private sector that could have informed an accurate calibration; fails to consider alternative, more accurate measures of risk, including some negotiated by agency staff at Basel; and ignores altogether a duplicative capital charge imposed by the Federal Reserve through its annual stress test. The only solution to its fatal substantive and procedural flaws is for the agencies to re-propose the rule.
“The proposed rule generally lacks any evidence to support the capital charges it assigns; in some cases, it it ignores what evidence is available; it treats as a binding treaty an agreement negotiated by agency staff that was never reviewed by the Congress, yet even then arbitrarily departs from that agreement to impose still higher capital charges on U.S. banks. By failing to show their work, and failing to consider important parts of the problem, the agencies have prevented meaningful comment not only by banks directly affected by the proposal but also by consumers, businesses and financial market participants who will see real costs as a result.” – BPI President and CEO Greg Baer
The proposal’s fundamental legal problems include:
- Risk weights for bank assets – such as mortgages and small business loans – untethered to an objective standard and unsupported by empirical evidence or analysis.
- An operational risk charge likewise grounded in no objective standard and based on unfounded assumptions about the risks of certain business activities and the nature of operational risk.
- Elimination of the role of bank internal models in calculating credit risk without appropriate justification, even though they are more accurate and granular than government models.
- The unjustified punitive capital treatment of bank lending to smaller businesses that are not publicly traded companies.
- Reliance on opaque data and analyses to calibrate the capital requirements for operational, market and credit valuation adjustment risks without making such data and analyses available for public comment.
- Disparate treatment of the international Basel agreement – in some aspects, the banking agencies copy the Basel agreement without any independent analysis, and in others they deviate from it without explanation.
- Missing the big picture: The proposal fails to account for the complex confluence of different elements of the capital regime and the impact to the broader regulatory and market landscape, such as capital requirements that duplicate those in the stress tests or subjecting different banks to different capital requirements for identical loans and activities. It also fails to consider the costs to society from driving more lending and intermediation to nonbank financial firms.
- Contradicting reality: The proposed rule rests on paltry economic analysis that is inconsistent with available evidence, and it would significantly increase large banks’ capital requirements despite evidence that their current requirements are more than adequate.
- The Federal Reserve’s stress tests continue to show that banks can weather a disastrous economic downturn.
- A review of the academic literature demonstrates that banks’ capital falls in the middle of the range considered “optimal.”
Bottom line: The Basel proposal amounts to a tax on economic growth and essential banking products and services without the evidence, transparency and justification that a federal rulemaking requires. The agencies should re-propose the rule and follow the law by gathering rigorous evidence to justify their proposed charges.
1. Inside Barr’s Q&A: The Surprise Announcement
With only a few days left before the Basel proposal comment period closes, at a recent Women in Housing and Finance Q&A Federal Reserve Vice Chair for Supervision Michael Barr announced that policymakers will release the Fed’s analysis of the quantitative impact study and give the public an opportunity to comment on the analysis before they finalize the Basel proposal.
- Op risk: Barr indicated that policymakers may be open to different approaches on a key input into the operational risk charge – the internal loss multiplier. He appeared to be open to set ILM to a fixed number and suggested that they could look into netting to address the overcapitalization of op risk for high fee income banks
- Mortgages: Barr emphasized the need to calibrate capital requirements carefully for mortgage lending
- Stress scenarios: Barr also said the Fed plans to develop non-binding “exploratory scenarios” for its stress tests in order to diversify how the banking system prepares for risks beyond the classic severe recession scenario in the usual stress tests. Although the scenarios would not determine banks’ capital requirements like the regular stress tests do, they could “feed into supervisory judgment,” Barr said. That comment suggests that they could inform how examiners evaluate banks’ performance in the closed-door supervisory process.
2. A Better Way to Assess the Economic Impact of the Basel Proposal
Federal Reserve Vice Chair for Supervision Michael Barr said the Basel capital proposal would have a minimal impact on the cost of lending: only 3 basis points, or 0.03 percent. But that calculation omits several important factors. A new BPI analysis outlines a more comprehensive way to evaluate the proposal’s cost to the economy, which affects everything from bank loans to asset management and broader market liquidity. The Agencies should make full use of this analysis and the newly collected data in their own quantitative impact study and re-propose the rule in full.
What’s missing: The banking agencies’ analysis inexplicably leaves out $1 trillion from the nearly $2 trillion increase in risk-weighted assets for operational risk. The operational risk capital charge is a key component of the proposal that would impose a broad tax on all banking activities.
- The missing portion in the proposal’s analysis relates to the “services component” of the operational risk charge, which captures fee-based income. Our analysis shows that about one-third of the risk-weighted assets generated by this component are linked to lending activities, such as credit card revenue and fees on lines of credit more broadly. The other two-thirds are related to trading activities and non-lending services, such as asset management, fees and commissions from securities brokerage and fiduciary activities.
- The higher borrowing costs omitted in the proposal’s analysis would make essential financial products more costly, such as credit cards and low down-payment mortgages and credit cards.
- Additionally, it is not just lending that is affected – higher costs in banks’ trading and financial intermediation activities such as holding inventories of securities, pricing derivatives, and performing asset management tasks. These higher costs are likely to be passed on to consumers, leading to broader knock-on impacts. Furthermore, the proposal’s overall costs on non-lending related business lines discourage banks from diversifying from pure lending services.
- Banks decide how much capital to allocate to each business line, such as credit card lending, mortgage lending, and market making, by considering the costs associated with each individual line. The agencies should evaluate their proposal’s impact on financial intermediation costs in a similar way. Focusing only on the average capital effect across all business lines obscures important details about how the proposal will affect specific types of lending and other financial intermediation activities performed by banks.
A more comprehensive way to conduct the economic impact analysis: Publicly available data limits analysts’ ability to allocate the op risk services component across the various lines of business of banks. However, the agencies can and should leverage information from the Federal Reserve’s quarterly FR Y-14 regulatory reports to assess the costs of the bank capital proposal. Several business lines will face disproportionately high capital charges once the full picture of the impacts of operational risk is considered.
3. ‘Trapped’ Bank Capital Makes Financial System Fragile
A global regulatory regime that keeps capital “trapped” in specific jurisdictions will make financial markets more vulnerable to shocks, Barclays Head of Research Jeffrey Meli wrote in a recent Financial Times op-ed. New regulations like the Basel proposal will likely exacerbate this “calcification of markets,” according to the article.
- How it works: Short-term funding markets have become more brittle because bank capital has become more “local”: separated by jurisdiction and less able to move freely between different bank subsidiaries. “Capital mobility has become time-consuming, costly and uncertain,” Meli wrote.
- The risk ahead: Higher capital requirements from the Basel changes would make it costlier for banks to intermediate in markets. That could push spreads wider and lead to price and yield volatility, which would then push requirements up even further.
- Also in the backdrop: One of the key markets at risk of instability is the Treasury market. The SEC recently issued new rules requiring more U.S. Treasury trades to be centrally cleared. While this step may decrease some pressure in the market, “the new rules are no panacea,” Meli wrote. Another factor in the Treasury market: the expanding need for government financing.
4. The Crypto Ledger
Here’s what’s new in crypto.
- Hacked: The SEC said its X (formerly Twitter) account was hacked after an attacker tweeted that spot bitcoin ETFs had been approved by the agency. The hack has raised questions about the regulator’s potential cybersecurity vulnerabilities. The incident occurred before an expected SEC vote on bitcoin ETFs.
- The actual vote: The SEC this week voted to approve certain bitcoin ETFs, which will broaden access to the products to ordinary investors. Chairman Gary Gensler cautioned that the move was not an endorsement of bitcoin and investors should “remain cautious about the myriad risks associated with Bitcoin and products whose value is tied to crypto.”
- New York bitlicense oversight weaknesses: The New York state comptroller recently released a report criticizing the New York Department of Financial Services’ oversight of firms with “bitlicenses”, such as Paxos, Circle and Coinbase. The report points to a risk that licenses may be granted to firms whose financial stability or cybersecurity standards have not been fully vetted. It also flagged lapses in background check processes and the possibility that application approvals may have been based on outdated information.
5. A Key Variable in the Future of Banks and AI: Talent
A recent Harvard Business Review article examined the prospects of artificial intelligence in banking. The article suggests ways that banks can maintain resilience in the face of any potential disruption of AI. One noteworthy takeaway from the article is the role of talent: “Over the past two years there has been a massive migration of AI talent from big banks to big tech companies. We analyzed the LinkedIn data of 5,000 AI executives in finance (VP level and above) who have left banking and found that the typical bank loses four AI people for every five that it hires. When AI talent leaves the biggest banks, they usually leave the industry altogether, finding new roles at tech giants like Amazon, Google, and Microsoft. These three tech companies have quietly been building a workforce of AI expats from the biggest banks.”
In Case You Missed It
G30 Releases Report on Bank Failures, Liquidity and Other Topics
The Group of Thirty released a new report on Tuesday, “Bank Failures and Contagion; Lender of Last Resort, Liquidity, and Risk Management”. The report is available here. The Group of Thirty is an organization of past and present leaders of central banks and other financial agencies around the world. The working group that wrote the report was chaired by Bill Dudley. Stijn Claessens was the project director and Darrell Duffie and Trish Mosser were project advisors. The report consists of an analysis of the spring 2023 failure of Silicon Valley Bank, Signature Bank, First Republic Bank, and Credit Suisse and a series of related policy recommendations. The key recommendation of the report is that all banks maintain collateral at the discount window plus reserve balances equal to uninsured deposits and short-term borrowing, and, in support, that the Federal Reserve improve the efficiency of its collateral management operations.
BPI commends the G30 and authors for a thoughtful report and support many (though not all) of its policy recommendations. The report recognizes that central bank lending is a critical part of bank liquidity risk management and needs to be factored into regulatory requirements and supervisory expectations for bank liquidity, that it is better for society if banks keep making loans to businesses and households that they can pledge as collateral to the discount window than simply requiring banks to hold ever-larger stockpiles of reserves at the Fed or lend even more to the U.S. Treasury, and that the entire liquidity regulation framework warrants careful review and reconsideration. At the same time, the report emphasizes that banks bear primary responsibility for their liquidity risk management and should not be protected from poor decisions.
The report also recognizes that the implementation of the key proposal will require a lot of additional analysis about available collateral and the stability of different types of bank liabilities, and that some banks have specialized business models that may require adjustments. Although a lot of work needs to be done, the report’s main recommendation provides a good starting point for careful policy study of the future of the bank liquidity framework and the role of central bank lending in that framework.
That being said, there are some recommendations with which BPI disagrees. To learn more, click here.
Regions Bank Launches Enhanced Program to Support Women’s Wealth-Building Pathways
Regions Bank last week announced the launch of a new program, Women + Wealth, aimed at advising women on their pathway to investment and wealth-building. The program targets a diverse audience of women and offers advice, guidance and resources for women in making key financial decisions.