BPInsights: Sept 14, 2024

Barr Unveils Basel Reproposal

Federal Reserve Vice Chair for Supervision Michael Barr this week unveiled the contours of a Basel Endgame reproposal. In response to a deluge of comments from a range of stakeholders – from housing advocates to farmers – the banking agencies will repropose the Basel Endgame rule with “broad and material changes,” Barr said. On average, the increase in capital under the reproposal would be 9 percent for GSIBs, according to Barr. Here are some key takeaways:

• Regional banks: Under the new proposal, the only Basel measure applying to banks between $100-250 billion only will be a requirement to recognize unrealized gains and losses on their securities in regulatory capital, Barr said. The reproposal would also include “simpler” capital requirements for non-GSIB banks between $250-700 billion, according to Barr.
• Credit risk: The reproposal will reduce the risk weights for residential real estate and retail exposures; extend the scope of the reduced risk weight for certain low-risk corporate debt; and eliminate the minimum haircut for securities financing transactions. Specifically, the new proposal would lower the risk weight for investment-grade debt for non-publicly-traded regulated financial institutions that are not banks (such as pension funds and certain mutual funds). It would also lower capital charges for mortgages with higher loan-to-value ratios (used often by first-time or minority homebuyers) and for credit card exposures where a borrower only uses a small part of the credit line. The reproposed measure would also significantly lower the risk weight for tax credit equity funding structures.
• Op risk: The reproposal would make several changes to operational risk, a key problem area in the original proposal, including: eliminating the internal loss multiplier, a coefficient that adjusts a bank’s operational risk charge based on its recent history of such losses; calculating a bank’s fee income on a net basis; and reducing operational risk capital requirements for investment management activities to reflect the lower risk of losses surrounding that business line. The original proposal’s operational risk framework was noticeably punitive toward fee-based revenue and businesses like wealth management.
• Market risk: The market risk capital aspect of the proposal – which was and is still expected to be a significant source of capital increases – would undergo changes in the new version, Barr said. The reproposal would permit banks to use internal models to capture market risk, with certain restrictions; make clarifications to enable banks to recognize hedging across mortgage-backed securities; and reduce capital for parts of client-cleared derivatives transactions.
• GSIB surcharge: Barr will recommend that the GSIB surcharge, a charge levied on the largest globally active banks, be adjusted to account for economic growth since it was adopted in 2015. As it stands, the GSIB surcharge can result in higher capital charges simply due to growth in the economy rather than growing risk on banks’ balance sheets—an issue the Fed promised to address in the original rule nearly 10 years ago. In addition, the GSIB surcharge will be automatically adjusted for economic growth in the future.
• Process: Barr claimed in a Q&A following his remarks that the agencies “decided to go above and beyond what is required under the Administrative Procedure Act by asking for additional data,” noting specifically that “people will be able to see, in detail, the special data collection, not only as it applied to our original proposal in 2023 but as it relates, more importantly, to the changes that we’re making.”  It remains to be seen how the Fed plans to use the QIS data to reflect changes introduced in the reproposal.
• BPI’s response: BPI issued a statement in response to the Barr announcement. “BPI and its members look forward to reviewing the announced reproposal of the Basel III Endgame. We remain concerned about the process and the analytical rigor behind the proposal. The focus should not be on reaching a politically expedient top line number but rather a bottom-up evaluation of each aspect of the rule to ensure it is based on data and proper analysis, not just a haircut on faulty math of the original proposal,” the statement said. Read the full statement here.
• Next steps: Barr said the Federal Reserve will hold an open board meeting to vote on the reproposal, and that it would get “broad support,” but he declined to “vote-count” how many governors would support it. The FDIC and OCC will also need to weigh in on it.

Five Key Things

1. Former CFPB Official: Banks Aren’t Over-Regulated, They’re Over-Supervised

“Banks are not over-regulated, but they are — quite dramatically — over-supervised,” former senior CFPB official Raj Date wrote in a recent edition of his new publication, The Open Banker. It is difficult for an outsider to fathom the sheer magnitude and intrusive nature of such supervision, he wrote. “The expense of this oversight – and believe me it is incredibly expensive – would surely be worth it if our supervisory efforts were laser-focused on critical risks, provided real-time directives to fix problems, and gave banks a clear understanding of the rules of the road. But that is not the case,” he said. He details an “obsessive focus” on process over substance; a lagging timeline that makes some examination findings “anachronistic”; and a culture that stifles innovation. “Today’s supervisory approach also encourages sclerosis in what otherwise should be a dynamic and innovative banking sector,” he said. “Because the “management” component of the so-called CAMELS ratings is so susceptible to inherently subjective criticism of internal processes and procedures, it becomes a useful tool to stand in the way of — or stonewall through a never-ending series of questions — virtually any bank customer or product strategy that might be novel or innovative or just disfavored, despite not presenting any non-trivial risk to safety and soundness.” He also discusses how to fix the problem, saying “the only solution is strong top-down leadership that imposes ambitious goals.”

2. Bank of England Outlines Basel Capital Package

The Bank of England on Thursday released a near-final policy statement and rules on the Basel capital standards. The changes will ultimately lead to an aggregate increase in capital requirements of less than 1 percent (from January 2030, when the transition period of implementing the rules ends), according to the BoE. However, larger U.K. banks will face a higher increase in capital requirements. “The near-final policy statement will give certainty to firms on their future capital requirements and deliver a better balanced and risk-sensitive approach to calculating regulatory capital under the Basel 3.1 framework,” the PRA said in a release. Changes compared to the original proposal include:

• Lower capital requirements for small and medium enterprise (SME) exposures.
• Lower capital requirements for infrastructure exposures.
• Lower capital requirements for trade finance-related activities.
• A ‘simpler, more risk-sensitive approach’ to valuing residential property.
• An adjusted approach to calculating the output floor.

Next steps: Citing the need for smooth implementation, feedback from stakeholders and “the implementation timelines of other jurisdictions”, the PRA said it has delayed the Basel implementation date by six months to Jan. 1, 2026 with a four-year transition period.

BPI statement: BPI issued a statement on the Bank of England’s release. Read it here.

3. Right-Sizing Bank Regulations Requires Adjusting Them for Economic Growth and Inflation

Many banking regulations vary based on banks’ size, risk profile and business model. These regulations are based on fixed thresholds, such as the size of a bank’s total exposures. But when these thresholds are not adjusted to account for economic growth and inflation, they can become outdated. Without such adjustments, banks could face unnecessarily stringent regulations despite their risk level not actually increasing. That mismatch limits banks’ ability to make loans and support the economy, and it contradicts the goal of tailoring requirements to banks’ different profiles.

• Evolving economy: Economic growth and inflation do not increase risk in the financial system. Sectors of the economy grow proportionally as the economy expands. Households’ incomes rise and their credit improves, so consumers can afford to take out larger loans to buy houses, purchase cars, renovate homes or finance a business. Economic growth enables new businesses to launch and existing businesses to expand their operations. Banks support these activities by extending credit. Inflation causes prices to rise and borrowing levels increase accordingly.
• Overdue for an update: Several rules require the banking agencies to make regular updates to their thresholds, but these adjustments have not been made in many cases. Other regulations do not explicitly require updates but suggest that regulators should reconsider thresholds when necessary. The Federal Reserve’s GSIB methodology hasn’t been updated in nearly a decade. Moreover, the Fed should introduce automatic adjustments to fixed regulatory thresholds based on indexing to economic growth, like nominal GDP.
• Current context: The need to update regulatory thresholds for economic growth has become more urgent in light of the significant inflation and financial system expansion after the COVID-19 pandemic.
• Examples: The GSIB surcharge imposed on the largest banks is an example of a threshold that should be updated for economic growth. Another example is the tailoring thresholds – nominal thresholds for certain risk-based indicators to determine how much prudential regulations are adjusted for banks of different sizes.
  • The largest banks’ capital requirements have increased 10 basis points a year on average, solely based on economic growth and inflation.
• Bottom line: The regular adjustment of regulatory thresholds to account for economic growth and inflation is crucial for maintaining an effective, balanced financial regulatory framework. BPI’s analysis demonstrates that both the tailoring category thresholds and the GSIB surcharge coefficients would benefit from such adjustments.

4. 4 Key Considerations on ‘Evolving Bank Supervision’

In remarks last week, Acting Comptroller Michael Hsu described the OCC’s evolving views on bank supervision. The focus on supervision in public remarks is a welcome development given the expanded and problematic state of the examination system, which increasingly focuses on immaterial matters and frequently undermines regulatory policies established by banking agency principals. Four aspects of the speech merit further discussion:

1. Prioritizing risk-based supervision. Hsu’s remarks emphasized the importance of a risk-based approach to supervision, rather than rote box-checking exercises – an approach that focuses attention on the most pressing issues. This is exactly what bank supervision needs – it would ensure bank examiners’ time, attention and demands are focused on real, material sources of risk rather than process for process’ sake. But bankers’ actual experience runs contrary to what Hsu’s speech describes: examiners focus on process rather than substance, and on immaterial matters rather than material financial risk. The Acting Comptroller’s remarks do not acknowledge the yawning gap between aspiration and reality. While the speech identifies steps the OCC is taking to embrace risk-based supervision, the references are vague and insufficient compared to concrete progress.
2. Asymmetries of supervision. Hsu’s remarks also stress the asymmetric public perception of bank supervision due to its secrecy; the public only hears about bank supervision when something has gone wrong. The inherent asymmetry in supervision means that bad supervision – including cases where supervisors focus on immaterial matters at the expense of real problems — is just as likely to go unnoticed as good supervision.
3. Horizontal supervision. Hsu’s speech discusses the shift to a more nimble approach reliant on horizontal supervisory teams and exams, rather than onsite teams dedicated to specific banks. Horizontal approaches may have certain benefits, but they also risk becoming a mechanism for examiners to prescribe one-size-fits-all practices among banks based on a preference for one bank’s strategy.
4. ‘DSIB’ designations. Hsu also suggests that the U.S. banking agencies consider a framework for formally identifying domestic systemically important banks, or DSIBs. He points to a purported increase in the number of large banks and the 2023 bank failures. In reality, such a framework has already existed for some time under U.S. law. The suggestion that the failures of SVB, Signature and First Republic justify rethinking what constitutes domestic systemic risk is also misguided.

5. How Do Synthetic Risk Transfers Work?

Recent commentary has raised concerns about banks using synthetic risk transfers to transfer default risk on credit assets to third parties. Here’s how these capital planning tools work, why banks use them and why concerns about them are unfounded.

• What they are: SRTs are structures used by banks to allocate regulatory capital more efficiently by transferring credit risk to outside investors. “Synthetic” refers to the fact that, rather than selling the loan portfolio outright, the bank keeps the portfolio on its balance sheet, but pays outside investors to bear some of the credit risk on the portfolio. Such transfers reflect, and are motivated by, how standardized risk weights under the regulatory capital rules diverge from actual historical loss rates for a particular asset class. Two common examples are credit-linked notes and credit default swaps. With CLNs, banks sell securities to investors for cash; if the underlying pool of loans incurs more losses than expected, the bank pays back less on the bonds. CDS is like buying insurance on loans from an investor.
• The background: SRTs have risen in prominence because of the standardized approaches under the Collins Amendment, a U.S. approach to bank capital that misaligns capital risk weights with the actual risk of banks’ assets.
• A rational economic choice: SRTs convert a bank’s credit exposure on an underlying loan portfolio into a securitization exposure for regulatory capital purposes. By reducing the bank’s exposure to unexpected losses, SRTs lower the amount of capital the bank must hold against the loans. This conversion allows banks to reallocate capital to other lending activities while maintaining their client relationships, and can enable banks to continue funding business lines that may otherwise be uneconomic due to capital requirements.
• Mitigating concerns: The guide responds to several concerns raised about SRTs. First, CLNs are not the same as asset-backed securities (known for their role in the Global Financial Crisis). Second, the primary investor base for SRTs appears to be private credit funds, which maintain limited, relatively low leverage and can easily absorb potential losses. Third, the systemic impact and scalability of SRTs is limited by the regulatory approval requirements involved and the high cost of risk mitigation options for banks to transfer credit risk to third parties.

In Case You Missed It

Bipartisan Congressional Letter Calls for Delay on Long-Term Debt Rule

A bipartisan pair of House lawmakers urged banking regulators in a letter this week to delay action on the long-term debt proposal to account for interactions with the Basel proposal while that rulemaking is still being reconsidered, according to Capitol Account. “Further action on the Long-Term Debt Proposal should be delayed at least until such time as may be necessary to determine what long-term debt requirements will look like in the context of new risk-weighted asset rules in the Basel III endgame re-proposal,” Rep. Brad Sherman (D-CA) and William Timmons (R-SC) wrote in a letter. The amount of debt that banks must issue under the long-term debt proposal would be determined by risk-weighted assets, which may change as a result of the Basel measure – in other words, the two proposals are intertwined. Gruenberg said recently that he hopes to finalize the long-term debt rule in the near future, and Fed Vice Chair for Supervision Michael Barr said in a Q&A this week that the central bank is aiming to finalize it “relatively soon, in Federal Reserve terms.”

Fed’s Bowman Suggests Stress Test Reforms

Federal Reserve Governor Michelle Bowman this week outlined potential improvements to the stress testing regime in a speech. Here are some highlights.

• Volatility: Bowman flagged the challenge of capital requirements changing year to year based on the stress tests. Volatile stress test results can necessitate banks holding “uncertainty buffers” and disrupt their ability to plan how to allocate capital in the long term, she noted. The short turnaround for compliance with stress capital buffers “compounds the issue of excessive year-over-year volatility,” she said.
• Link between stress tests and capital: A key part of large banks’ capital requirements is directly linked to their stress test results. As the Fed considers stress-testing multiple scenarios, questions arise about how to link test results and capital requirements; “a more robust use of stress testing would require rationalizing the link between stress testing and capital to ensure that any change in overall calibration was driven by an intentional process that results in a reasonable policy outcome,” Bowman said. “In my view, an up-calibration of capital requirements through an expanded scenario-testing regime would not be supportable based on the underlying risks.”
• Lack of transparency: Bowman also called for greater transparency in stress testing, from the models to the reconsideration process. Enhanced transparency would enable banks to better manage their business and make more informed decisions about allocating capital, she said. She also addressed the notion that transparency would lead to “gaming”: “I think this misinterprets the dynamism and review that should complement the stress testing process,” she said.
• Due process: Bowman observed that the Fed recently modified a stress capital buffer for one bank based on its reconsideration request. “While firms subject to the stress test have long had the ability to request reconsideration—and many have done so in the past—this was notable as it was the first time that a reconsideration request was successful in producing a change to a firm’s stress capital buffer,” she said.
• Overlap: One problem with stress testing is its overlap with proposed Basel Endgame changes to capital requirements, Bowman said – namely in the Global Market Shock and operational risk elements of the framework. “We need to ensure that the risks captured and methodologies underpinning these distinct requirements do not lead to an over-calibration of capital requirements for activities that support the important role of U.S. capital markets in the global economy,” she said.

SEC’s Gensler Outlines What Banks Must Tell Investors in Resolutions

SEC Chair Gary Gensler laid out in a speech this week what banks should tell markets in the event of a restructuring amid a potential failure. Gensler described disclosure to investors as a “public good” and emphasized the importance of private sector investors, rather than taxpayers, bearing the costs of a bank’s failures. “If a large financial institution is restructured, the market’s need for disclosure doesn’t go away,” Gensler said. “Indeed, I believe the market’s need for robust disclosure becomes all the more critical.” Such disclosures ensure investors, counterparties and depositors have confidence to remain with the bank, he said. He also suggested that the best time to prepare for such disclosures is “when there isn’t a tornado.” The speech described disclosures banks have to make in the context of resolution planning and strategy development, as well as during and at the point of failure.

• Who are the stakeholders? Disclosures are important to debt and equity holders of the bank, its counterparties and its depositors, particularly uninsured ones, Gensler said. He noted the importance of maintaining trust among these parties and avoiding asymmetry in incentives.
• Pressing questions: Gensler outlined some key questions that market participants would likely have for a restructuring bank, such as: What does the restructured institution look like? Is the institution still a ‘lemon’? What is the core business strategy going forward? Who is the new management team? The timing of answering such questions is important, he said. “Given how important prompt disclosures will be to the success of any such restructuring, the lawyers, accountants, and management of global systemically important financial institutions should be including in their plans how they would prepare for the disclosures that the capital markets would demand on the Monday (Asia time),” he said.
• Above and beyond: “During discussions about financial institution disclosures with market participants and regulators, the SEC is regularly asked about what is required under U.S. securities laws,” Gensler said. “As important as the details of securities laws are, though, the goal is to have private sector investors—rather than the taxpayers—bear the brunt of a systemically important financial institution’s restructuring. The best way to achieve that is through robust disclosures that meet market expectations, not just legal requirements.”

Rep. Andy Barr: Basel Proposal is ‘Recipe for a Recession’

Rep. Andy Barr (R-KY), chair of the House Financial Services Subcommittee on Financial Institutions and Monetary Policy, joined a recent Banking with Interest podcast episode to discuss several bank regulatory topics, including Basel Endgame. Barr also discussed other policy priorities such as M&A review and fair access. Barr is campaigning to lead Financial Services Committee Republicans next year. When asked about the Basel proposal, Barr said: “This proposal was gold-plating, it was a regulatory non-sequitur” and said SVB’s failure wasn’t a capital inadequacy issue. He referred to it as a “fundamentally flawed proposal” and reiterated the need for a full reproposal, not a partial one. (The interview took place before Michael Barr’s speech this week.) The Basel III Endgame proposal is a “recipe for a recession,” Rep. Barr said.

• Other topics: He emphasized the unintended consequences of the Regulation II debit interchange proposal as a “huge concern.” “This proposal…would further push many Americans into the category of the unbanked or underbanked,” Barr said. He also stressed the need to balance regulation with a competitive banking system. “I believe in diversity within our financial ecosystem, both for American competitiveness [and] economic growth but also for financial stability,” Barr said. “That means a strong banking system, and overregulation of the banking system has, I think, threatened both our competitiveness and financial stability.”

Senate Democrats: Fed Payments System Should Be a 24/7 Business

An economy that operates 24 hours a day, seven days a week, 365 days a year, demands a federal payments system that is open 24/7, five Senate Democrats told Fed Chair Jerome Powell in a recent letter. The lawmakers, led by Senate Banking Committee Chair Sherrod Brown (D-OH), were writing in support of a May 2024 Fed proposal to expand the operating days of Fedwire and the National Settlement Service to include weekends and holidays, while encouraging the Fed to go further and keep the systems open 24 hours a day. “The proliferation of mobile devices and the expansion of e-commerce underscore the 24/7 nature of business, making it possible for Americans to book flights, buy concert tickets, and shop for gifts at all hours of the day,” the lawmakers wrote. “For most Americans it makes no sense that they must wait for their money to be deposited in their bank accounts.” Avoiding gaps in cash flow with expanded payment system hours would benefit small businesses and lower-income Americans, the lawmakers said.

The Crypto Ledger

Here’s the latest in crypto.

• SAB 121: SEC Chief Accountant Paul Munter gave remarks this week highlighting exceptions to the agency’s SAB 121 policy, which aims to require banks to account for digital assets held in custody for clients on their balance sheets, a departure from traditional treatment of safeguarded assets. Specifically, Munter noted instances where the SEC’s accounting staff did not dispute a firm’s conclusion that its arrangement was not in the scope of SAB 121. Munter said the SEC staff’s views in SAB 121 remain unchanged, but explained that the staff have received inquiries about a range of other scenarios involving digital assets safeguarding and the use of distributed ledger technology; firms have demonstrated in certain cases that the specific factors in these scenarios differ from those contemplated in SAB 121. He indicated a case-by-case approach to such arrangements. His examples can be found in his remarks here.
• Tethered to the underworld: The Wall Street Journal published a deep dive piece this week on stablecoin Tether’s role in the “financial underworld,” from drug cartels to sanctioned nations.  
• UK bill: The UK government introduced a bill to Parliament clarifying the legal status of digital assets, including cryptocurrencies.

BofA’s Moynihan Talks Economic Outlook, Basel Endgame on CNBC’s Power Lunch 

Bank of America CEO Brian Moynihan joined CNBC’s Power Lunch this week to discuss a range of topics, from the economic outlook to AI to Basel Endgame. On the Basel proposal – specifically, the difference in the average capital increase between the original proposal and the previewed reproposal — Moynihan said: “It feels a little like that old phrase, ‘We’ll show them death and they’ll take despair.’” He emphasized that banks already have ample capital and have withstood real-life stress tests. The U.S. banking industry is “the envy of the world,” he said.