Impending tougher capital requirements for the largest banks will require some to build capital and could change the way they provide financial services, according to Federal Reserve Vice Chair for Supervision Michael Barr.
Speaking on July 10, Barr outlined specifics for coming heightened capital rules for banks with over $100 billion in assets. Though the details come after a holistic capital review that began nine months ago, it is largely influenced by the recent failures of three regional banks that emphasized "the importance of resilience," Barr said in written remarks.
Impact of proposed Basel III changes
Barr estimated that the coming Basel III endgame proposal would require banks with more than $100 billion in assets to hold an additional 2 percentage points of capital, or an additional $2 of capital for every $100 of risk-weighted assets.
Barr estimated that "most banks" already have enough capital today to meet that. The banks that do not should be able to build to that level in less than two years through retained earnings while maintaining their dividends, assuming they earn money at the same rate they have in recent years, he said.
A recent analysis by S&P Global Market Intelligence found that half of the large US banks would need to build capital under heightened capital requirements.
While many banks already meet the potential heightened standards currently, Barr did acknowledge that the changes could lead to some banks changing their behavior, particularly as it relates to the way financial services are provided, but "the benefits of making the financial system more resilient to stresses that could otherwise impair growth are greater," he said.
Basel III proposal
Barr outlined a number of changes that will be included in the coming proposed rule updating the US capital framework to finalize Basel III. There was consensus among the agencies that "current rules underestimate risks for the largest, most complex banks," he said.
Barr will recommend that the proposal target banks with more than $100 billion in assets after "our recent experience shows that even banks of this size can cause stress that spreads to other institutions and threatens financial stability."
Requiring banks to account for unrealized loss and gains in their available-for-sale (AFS) securities portfolios when calculating regulatory capital is among the changes coming in the Basel III endgame proposal. Such change "would better reflect banking organizations' actual loss-absorbing capacity," Barr said, noting that realizing losses from securities without enough capital to protect from those losses led to Silicon Valley Bank's demise.
Further, banks currently required to reflect those unrealized losses and gains in their capital ratios manage "their interest rate risk more carefully, suggesting that the requirement to include gains and losses on AFS securities in regulatory capital leads to stronger risk management as well."
Currently, only global systemically important banks are required to take those marks against their capital ratios.
The Basel III proposal also seeks to put a stop to banks' reliance on their own individual estimates of their risk as it relates to their lending activities. Currently, the largest banks use their own internal models to estimate credit risk, but "banks tend to underestimate their credit risk because they have a strong incentive to lower their capital requirements," Barr said.
Under the proposal, there will be standardized credit risk approaches, which will apply the same requirements to each bank.
The proposal will also introduce a standardized model for operational risk that will be based upon a bank's activities and then adjusted upward based on the institution's historical operational losses.
Regulators also plan to adjust how banks measure their market risk for trading activities. Banks will continue to use their internal models, but the proposal aims to raise the standards for those models, Barr said. It will also introduce a standardized approach for use when the internal modeled approach "is not feasible," he said.
Since the risk models will be uniform and not require developing credit risk and operational risk models, it will be "less burdensome" for banks with between $100 billion and $700 billion in assets that are not currently subject to these rules to comply, Barr said.
Other capital changes
Barr also highlighted other potential capital changes outside of Basel III.
While the Fed's stress testing framework "generally remains sound," the agency plans to "review our global market shock and the stress test's approach to estimating operational risk so that they provide a complimentary lens to our risk-based standards on market risk and operational risk, respectively."
The agency also plans to address long-term debt, and Barr said he supports applying a long-term debt requirement to all banks with more than $100 billion in assets. Adequate long-term debt might have reduced run risk at Silicon Valley Bank, given the Federal Deposit Insurance Corp. additional options for resolving or merging it and reduced resolution costs for the FDIC, he said.
Aside from capital, Barr said he plans to discuss further changes in the regulation and supervision of "liquidity, interest rate risk, and incentive compensation, as well as improving the speed, agility, and force of the Federal Reserve's supervision" in the coming months.
