27 Jul, 2023

Regulators unveil long-awaited capital rule proposal for $100B+ banks

Regulators unveiled their much-anticipated Basel III endgame proposal, confirming that banks with more than $100 billion in total assets will be subject to the enhanced rules estimated to result in a 16% aggregate increase in common equity Tier 1 capital requirements for them.

Federal bank regulators will accept comments until Nov. 30, a time frame of about 120 days, which is longer than usual comment periods. After the rules are finalized, they would become fully phased in July 1, 2028, giving banks three years to comply.

Banking turmoil motivated components

Some of the proposed rules are a result of recent banking industry turmoil that resulted in three regional bank failures, according to the fact sheet for the proposal.

One rule is the inclusion of accumulated other comprehensive income (AOCI) in banks' common equity Tier 1 ratios, which includes unrealized losses and gains in available-for-sale securities. Currently, only global systemically important banks are required to do that, and banks with above $100 billion in assets can opt out.

Recent events show that unrealized losses "can have negative market perception and liquidity implications," so the inclusion of AOCI in capital ratios "achieves a better alignment of regulatory capital with market participants' assessment of loss-absorbing capacity," according to the proposal.

The events of the banking turmoil also motivated regulators to expand the number of banks that must comply with the supplementary leverage ratio requirement and the countercyclical capital buffer, if activated.

Other changes

The proposal also seeks to put a stop to banks' use of their own internal models for credit risk and operational risk, instead replacing internal model practices with standardized approaches.

"These internal models rely on a banking organization's choice of modeling assumptions and supporting data. Such model assumptions include a degree of subjectivity, which can result in varying risk-based capital requirements for similar exposures," the proposal read.

Speaking during the Federal Deposit Insurance Corp.'s board meeting, Chairman Martin Gruenberg said the agency "has long had concerns about the use of internal models in establishing minimum capital requirements for credit risk because of their lack of transparency and their variability of results." Gruenberg noted that the proposed changes "would improve the consistency and transparency of capital requirements and would enhance the ability of supervisors and market participants to make independent assessments of a banking organization's capital adequacy individually and relative to its peers."

Still, the proposal encouraged banks, especially large ones, to continue to use their internal models to inform their own stress testing, capital planning and risk management functions.

The proposal also revises the current approaches for market risk and credit valuation adjustment risk requirements.

Banks will continue to use their own internal models for market risk, but those models would "be subject to enhanced requirements for model approval and performance and a new 'output floor' to limit the extent to which a banking organization's internal models may reduce its overall capital requirement."

The proposal also seeks to raise the dollar-based threshold of trading assets plus trading liabilities for market risk compliance to $5 billion from $1 billion, or banks whose trading assets plus trading liabilities exceed 10% of total assets.

Banks with significant trading activity "are subject to substantial market risk," the proposal read.

For credit valuation adjustment risk, the proposal seeks to replace the current approach with non-model-based approaches, including a less burdensome option intended for less complex banking organizations.

Impact of changes

Many large US banks were anticipating these rules, with most holding off on capital spend measures like buybacks as they waited for clarity.

Federal Reserve Vice Chair for Supervision Michael Barr previewed the proposal earlier this month, where he estimated that the coming 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, 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.