BPInsights: July 29, 2023

From Starter Homes to Corporate Funding and Capital Markets Activity, Basel Proposal Puts Economic Growth and Market Liquidity at Risk

The U.S. banking agencies on Thursday released a proposal to implement Basel capital changes.

What it is
For large banking organizations, the Basel proposal would increase common equity tier 1 capital requirements in aggregate by around 16 percent, or about $200 billion. The proposal revises capital requirements for credit risk, market risk and introduces new capital charges for operational risk and credit valuation adjustment (capital charges for derivative transactions). Specifically, the proposal includes a massive increase in market risk in addition to the two new capital charges. It would apply these Basel-based risk measurements, as well as other elements of the capital framework previously only applicable to the largest banks (such as removal of the accumulated other comprehensive income, or AOCI, filter), to banks over $100 billion in assets—effectively reversing the regulatory tailoring framework for certain midsized banks. The impact on specific banks differs based on specific business models, but overall, the capital increase is dramatic and will drive banks’ business decisions. The business lines most strained by the proposal include mortgage lending, funding to corporates, market-making and trading intermediation and fee-based businesses like wealth management, investment banking, payment and custody services and payments.

What it means for the economy
The proposal will raise the cost and shrink the availability of credit, particularly for financing activities that generate the highest capital requirements, such as mortgage lending, funding to corporates and market-making. The risk weights for home mortgages with higher loan-to-value ratios – which are those with lower down payments, often first-time homebuyers – could ultimately make homeownership harder to access for families trying to build wealth. The changes to market risk, CVA, and operational risk will likely shift more financing into the shadow banking sector, such as hedge funds and private equity. This, in turn, could make the U.S. financial system less stable and resilient to economic shocks.

Cracks in the consensus
In a break from precedent, two Federal Reserve Board governors, Christopher Waller and Michelle Bowman, voted against the proposal. “I appreciate the work that staff has done on this Basel III proposal, but I am not convinced that it improves the resiliency of the financial system,” Waller said in a detailed statement. “At the same time, it will increase costs for families and businesses and could impede market functioning. I don’t think those costs are worth bearing without clear benefits to the resiliency of the financial system.” He also expressed concern about overlap with the stress tests. A dissent by more than one Fed governor on a regulatory proposal is unprecedented in recent years. “Today’s capital proposal could give the impression that undercapitalization of large banks is a major vulnerability in the U.S. banking system, or that higher capital levels would have addressed the management and supervisory shortcomings that contributed to the recent bank failures earlier this year,” Bowman said in a statement. “I do not see evidence to support these views.”

Another governor, Philip Jefferson, said he was “very concerned” about impacts on lending. “Can you give me a sense of how and to what degree these higher capital requirements could constrain a bank’s ability to lend to businesses and individuals?” he asked during the Board meeting. Jefferson said he “will evaluate any future proposed final rules on their merits”. Governor Lisa Cook also supported the proposal but asked how it would affect residential mortgages.

Federal Reserve Chair Jerome Powell also signaled misgivings. In his statement, Powell flagged several areas of the proposal for which he was particularly interested in comments: the calibration of proposed capital increases, both overall and “for specific areas such as capital markets activities and operational risk”; eliminating the advanced approaches; and striking the right balance for regulation and supervision of banks between $100-250 billion in assets.

At the FDIC, two commissioners, Jonathan McKernan and Travis Hill, voted against the proposal. McKernan noted the departure from global standards: “[T]his proposal generally deviates from these standards with a singular focus: pushing capital levels yet higher and higher. This reverse engineering of higher capital pays little heed to the associated economic costs and, if finalized, would result in a capital framework unmoored from the principles that have historically rationalized the framework.” Hill criticized the proposal’s rejection of the tailoring framework for midsized banks: “For purposes of the capital rules, the proposal effectively collapses Categories II, III, and IV into one category,” he said in a statement. “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. It is further a troubling sign for future policymaking, a signal that regulators intend to treat all large banks alike, in defiance of Congressional directives and in contradiction to the objective of a diverse banking sector with banks of varying sizes, niches, and business models.”

Bigger picture
As noted in Governor Bowman’s, Governor Waller’s, Commissioner Hill’s and Commissioner McKernan’s dissent statements, the proposal deviates significantly from the international Basel agreement. The U.S. banking regulators have effectively tacked surcharges onto Basel requirements without justification or a meaningful economic analysis. And the proposal fails to take into account the overlap between Basel requirements and the Fed’s own stress tests. It needs transparency, thorough analysis and a reality-rooted view of banks’ capital holdings.

Five Key Things

1. BPI Responds to Basel Proposal

BPI President and CEO Greg Baer issued a statement on this week’s Basel proposal from the federal banking agencies: “This week’s proposal would unnecessarily increase the amount of required capital for banks, with resulting harm for consumers and small businesses and a continued migration of financial activity into unregulated parts of the financial sector,” Baer said.

  • Bloomberg Radio: Baer discussed the Basel proposal on Bloomberg Radio’s “Sound On” with Kailey Leinz and Joe Mathieu on Thursday. Dramatic increases in capital charges for certain businesses such as trading activities and investment banking have real consequences for how banks do business, Baer said. He also noted the extreme rarity of two Fed governors dissenting on a proposal. “It’s very unusual to have two governors dissent,” Baer said. “That starts us off at a place where we rarely are.” In fact, the Federal Reserve’s website shows no instances of two governors dissenting on a proposal dating back to 2012, the earliest vote records available.
  • Basel between the lines: Baer and BPI Head of Research Francisco Covas led a Twitter Spaces discussion this week on the Basel proposal. Here are some key takeaways from that discussion, which broke down the potential impacts. The proposal will affect different banks in distinctive ways, Covas said. Banks “with large trading and market-making operations will bear the brunt of the increase in capital requirements,” he said. “The proposal is also very punitive for banks focused on fee-based revenue.” When people consider how banks will meet increased capital requirements, they assume it’s going to be “all numerator,” Baer said – by raising capital, for example. But they could also pull out of the business lines generating the highest capital charges, he said – “shrink the denominator.” The high charges for capital markets activities generating fee revenue could significantly affect the funding of corporations, Covas said. There is an overlap between the market risk captured in the stress tests and the new Fundamental Review of the Trading Book requirement in Basel, as both cover tail risk, he said. Baer, Covas and a panel of experts also discussed effects on mortgages and business funding, the potential for rapid changes to banks’ balance sheets and the near-complete reversal of tailoring.

2. Housing Advocates Letter: Higher Mortgage Capital Requirements Risk ‘Devastating Impact’ on Homebuyers

Significantly raising capital requirements on mortgages with less than 20% down payments would wreck homeownership prospects for first-time buyers, a coalition of housing advocates wrote in a letter this week to banking regulators. The coalition included the National Housing Conference, the NAACP, Mortgage Bankers Association, National Association of REALTORS and the National Urban League.

  • Particularly affected: Such capital increases would particularly pressure Black homebuyers, first-time buyers and those without generational wealth. These effects would damage efforts to increase homeownership among black consumers, the groups wrote.
  • Behind the numbers: The letter was sent before the banking agencies released their Basel proposal. However, the proposal would raise capital requirements around residential mortgages significantly, through higher risk weights for those loans. These increased risk weights, exceeding those under the Basel framework, will strain access to mortgages for first-time buyers and those with less than 20% down by assigning the highest risk weights to loans with higher loan-to-value ratios.

3. In the Shadows: Why Building Stress Tests without Transparency Is a Problem

This week, BPI and the American Bankers Association filed petitions for rulemakings with the Federal Reserve Board seeking release for public comment of both the supervisory models and stress scenarios that the Federal Reserve uses to calculate binding capital requirements through its annual stress tests. Those models and scenarios play a crucial role in setting minimum capital requirements for large banks, and as a result, have a direct effect on the availability and cost of credit across the economy. Nonetheless, to date the Federal Reserve has declined to seek public comment on its stress scenarios and has kept its supervisory models secret, in clear violation of the Administrative Procedure Act.

In their letter to the Fed announcing the petitions, the trade associations wrote:
“We believe that, by granting these requests, the Board can remedy the serious existing legal defects that currently undermine the credibility and effectiveness of the Board’s framework for setting stress-based capital requirements. In addition, granting these requests would acknowledge that the development of stress test models and scenarios is a complex and challenging task that could benefit from public review and a range of external perspectives, rather than relying solely on the views of the Board, its staff, and its private advisors.”

Since the conversion of the stress test to a binding capital charge in 2020, the Federal Reserve has made periodic commitments to enhance the transparency of its process. However, it has instead continued its policy of secrecy, even as its stress test has produced persistently volatile and counterintuitive outcomes. Thus, substantial year-to-year fluctuations in banks’ capital levels appear to stem from unexplained changes in Fed modeling rather than changes in the financial risks of the banks themselves. As a consequence, banks must hold additional capital to account for the uncertainty inherent in the Fed’s models, and they pass this cost on to households and business borrowers in the form of more expensive and less available credit.

To read more about this problem – and why this week’s Basel proposal makes it worse – click here.

4. Fed Releases Capital Requirements for Large Banks

The Federal Reserve on Thursday announced the individual capital requirements for large banks, effective Oct. 1. These requirements were driven in large part by the recent stress tests, which featured an extremely severe scenario. The capital requirements are composed of the minimum 4.5% capital requirement, stress capital buffer requirement of at least 2.5% and a GSIB surcharge for the largest globally active banks. During this year’s evaluation, 14 banks experienced a decrease in their stress capital buffer, while 8 banks saw an increase. Our post-mortem analysis revealed that two banks had a stress capital buffer increase of over 400 basis points due to a change in the Fed’s pre-provision net revenue models for those banks. Furthermore, the Fed’s press release noted that they had adjusted their own projections of accumulated other comprehensive income due to revisions from two incorrect data submissions. The list of capital requirements can be found here.

5. Bank On Continues to Play Key Role in Boosting Financial Inclusion

The Bank On program continues to demonstrate significant success in promoting financial inclusion and reaching communities in need, according to a new BPI analysis. The program — aimed at making low-cost transaction accounts more available — is experiencing strong take-up in predominantly minority and low-income populations, continuing a trend observed in previous years. This pattern signals a growing awareness of and utilization of the Bank On program and its effectiveness as a tool to bridge the financial divide.

Key highlights: The latest data show:

  • 5.8 million+ Bank On certified accounts were open and active, as of year-end 2021.
  • Neighborhoods with over 50% minority representation (13% of all neighborhoods) accounted for 32% of ever-opened accounts, underscoring the positive impact of Bank On transaction accounts on minority communities.
  • Neighborhoods with over 50% low- to moderate-income (LMI) households (20% of all neighborhoods) represented 40% of ever-opened accounts.
  • All states experienced substantial growth in Bank On accounts during 2021; net rates of account opening are very strong, consistently above 20% and mostly above 40%.
  • Bottom line: The data reasserts the vital role of Bank On transaction accounts and banks’ participation in fostering financial inclusion.

SEC Rule on Cyber Disclosure Risks Harming Investors, Exacerbates Security Risks

The SEC finalized a rule this week that requires public companies to notify investors when a cybersecurity incident has occurred, even if that incident is ongoing and exposes potential vulnerabilities at other companies or sectors. Heather Hogsett, senior vice president, technology and risk strategy for BITS — the technology policy division of BPI — issued the following statement:

“The SEC’s cyber disclosure rule risks harming the very investors it purports to protect by prematurely publicizing a company’s vulnerabilities. No reasonable investor would want premature disclosure of a cyber event to malicious actors or a hostile nation-state, which could exacerbate security risks and creates a recipe for disaster the next time a major cyber incident occurs.”

Since 2022, the SEC has proposed five separate rules to require companies to inform investors of their cybersecurity risk management practices. BPI has previously called upon the SEC to:

  • Coordinate with law enforcement and other stakeholders: There should be a mechanism that allows companies, in coordination with law enforcement and other regulators, flexibility to delay disclosures, focus resources on remediation and prevent widespread exploitation of an ongoing vulnerability.
  • Harmonize this new rule with existing disclosure requirements. Financial institutions — unlike other industries — must adhere to a long list of other federal and state obligations. These regulations include the Gramm-Leach-Bliley Act, the prudential financial regulators’ Computer-Security Incident Notification Rule, the New York Department of Financial Services Cybersecurity Regulation and other state-specific requirements. Financial institutions will also soon be required to comply with the Cyber Incident Reporting for Critical Infrastructure Act.

PacWest Plans to Merge with Banc of California

PacWest Bancorp and Banc of California announced a merger this week targeted to close at the end of this year or next year. After the deal is closed, the two institutions will operate under the Banc of California name. The combined bank will have about $36.1 billion in assets.

  • Context: PacWest was among the mid-sized banks experiencing stock pressures and depositor outflows in the wake of spring turmoil.
  • Deal structure: The deal is structured as a reverse merger with the smaller of the two banks, Banc of California, as the legal acquirer.  In contrast, PacWest will be designated as the acquirer for accounting purposes.  As a result, Banc of California’s balance sheet will be marked to market values, while PacWest, which has greater paper losses on its balance sheet, will avoid this treatment.  In this way, the deal overcomes a major holdup to transactions over the past year which has been the accounting requirement for acquirers to absorb paper losses that have accumulated on bank balance sheets as interest rates rose and the value of loans and bonds fallen.  The deal is also being facilitated by private equity fund equity investments and the sale of $1.8 billion in single-family mortgages.
  • Big picture: There has been very limited bank M&A activity following the series of government-negotiated sales of failed banks this spring.  Deals have been held up or abandoned due to both accounting and regulatory approval hurdles.  The deal is being announced against a backdrop of increasing wait times for Federal Reserve bank M&A approvals and at a time when the DOJ and banking agencies are currently weighing updates to bank merger policy. In June, the head of the DOJ’s Antitrust Division gave remarks in which he suggested that branch divestitures may not always be a sufficient remedy for competitive concerns presented by banking mergers involving geographic overlaps between the merger parties (PacWest and Banc of California both operate in California).

Bank Reg Tidbits from Powell’s Press Conference

Federal Reserve Chair Jerome Powell held his regular post-FOMC-meeting press conference this week. While many questions focused on monetary policy, the discussion included some references to bank regulation. Here are some highlights:

  • Stabilized: In response to a question about the PacWest merger and its implications for the spring bank turmoil, Powell said “things have settled down for sure out there” in the banking sector. “Deposit flows have stabilized, capital and liquidity remain strong. Aggregate bank lending was stable quarter over quarter and is up significantly year over year.” He went on to say that “overall, the banking system remains strong and resilient.” Powell indicated that some banks may be tightening credit a bit.
  • Making window less “clunky”: The Fed’s discount window “can be a little clunkier and not as quick as it needs to be sometimes,” as evident in the March failures, Powell said. “So, why not be in a situation where you’re just much more ready in case you need to access the discount window?” Banks are working now to ensure they’re ready to access the window, he said, and “we are strongly encouraging them to do that.”

D.C. Circuit Backs Class Certification in Visa, Mastercard ATM Fee Case

The U.S. Court of Appeals for the D.C. Circuit this week affirmed a lower court decision to certify three different classes of consumers and ATM operators accusing Visa and Mastercard of antitrust law violations related to ATM fees. A three-judge panel in the D.C. Circuit supported the 2021 class certifications that created two different classes of consumers and a third class of ATM operators, according to Law360. U.S. District Judge Richard Leon had rejected the card networks’ assertion that the different classes would draw in too many unharmed consumers or operators.

  • Context: The plaintiffs in the long-running ATM fee case accused Visa and Mastercard of artificially inflating customers’ ATM transaction costs, limiting owners’ revenue, and violating the Sherman Act’s prohibition on unreasonable restraint of trade. The case has been in D.C. federal court for over a decade.

The Crypto Ledger

The House Financial Services Committee this week advanced a bill to regulate crypto-asset market structure. The legislation, approved in a 35-15 bipartisan vote, would draw new lines in jurisdiction over crypto assets between the SEC and CFTC, which have both been eyeing the industry. The House Agriculture Committee also advanced its own crypto market structure bill. The House Financial Services Committee late Thursday also advanced a payment stablecoin bill. Here’s what’s new in crypto.

  • SBF bail: FTX founder Sam Bankman-Fried may go back behind bars. A judge is weighing whether to revoke Bankman-Fried’s bail after prosecutors contended that the disgraced crypto chief used the news media to harass a key witness.
  • Campaign finance: Federal prosecutors scrapped a campaign finance charge against Bankman-Fried. The decision not to pursue the charge stemmed from treaty obligations with the Bahamas, from which the founder was extradited.
  • Island bunker: Bankman-Fried’s brother, Gabriel, proposed to buy the Pacific island nation of Nauru with FTX funds and build an apocalypse bunker there, according to a memo cited in FTX’s lawsuit against Sam Bankman-Fried and other top executives.

Bank of America Awards $1M Grant to Juneteenth Museum

Bank of America this week announced it is awarding a $1 million grant to the National Juneteenth Museum. The foundational gift will support the first-of-its-kind museum, which will be built in Fort Worth.


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The views expressed do not necessarily reflect those of the Bank Policy Institute’s member banks, and are not intended to be, and should not be construed as, legal advice of any kind.