Basel III endgame: 5 things to watch in 2024

Because of their proximity to one another, the proposed capital reforms have sometimes been viewed as a response to the failures of three large banks this past spring. But that is not entirely accurate.


The Basel III endgame, as its name suggests, is rooted in the most recent global standards issued by the Basel Committee on Banking Supervision. Those standards are themselves an extension of a regulatory reform effort that emerged from the subprime mortgage crisis and ensuing global financial fallout. The primary purpose of the proposal is to align the U.S. with its global peers.


In a speech to the American Bankers Association in October, Fed Vice Chair for Supervision Michael Barr framed the proposal as an effort to "comprehensively address the lessons of the global financial crisis."


Yet, regulators have also invoked the failures of Silicon Valley Bank and others in their remarks about the need for capital reform. When the proposal was put forth to the public, Barr cited the episode as proof that higher capital requirements are in order.


"As we learned earlier this year, banks with inadequate levels of capital are vulnerable, and that vulnerability can cause contagion, which threatens the stability of the banking system and hurts families and businesses," Barr said, adding that a "clear message" from the failures was that "regulatory requirements, including capital requirements, must be aligned with actual risk so that banks bear the responsibility for their own risk-taking."


The bank failures, which include three of the four biggest in U.S. history, encapsulated the systemic risk posed by banks that are considered too big to fail. They also injected a sense of timeliness to reforms aimed at addressing a decade-old crisis. But the correlation has opened regulators up to criticism, especially in light of the assessment that additional capital alone would not have been to help Silicon Valley Bank or Signature Bank withstand their massive runs they faced.


In Congress, some Republicans have said the reform package is proof that regulators have learned the wrong lessons from the failures. During a Senate Banking Committee hearing in November, Sen. Steve Daines, R-Mont., admonished Barr, FDIC Chair Martin Gruenberg and Acting Comptroller of the Currency Michael Hsu for pursuing reforms that he felt did not address the core issues at play.


"We saw the bank failures earlier this year, I believe, as a result of regulators being asleep at the switch, as we probed in great depths in many of these failures," Daines said. "It's clear these failures were not due to insufficient capital. Nevertheless, you're moving forward with a flawed Basel III endgame proposal."


David Sewell, a partner at the law firm Freshfields Bruckhaus Deringer and a former regulatory and supervisory lawyer with the Federal Reserve Bank of New York, said using the regional banking crisis of this spring to give new life to longstanding bank regulatory priorities was a running theme throughout 2023. He noted that expanding resolution plans and long-term debt requirements are also examples of pre-existing agenda items that have been colored by the "specter of Silicon Valley."


Sewell said the failures did expose gaps in the regulatory framework, particularly for banks with between $100 billion and $250 billion of assets. But, he added, the scope of the crisis was ultimately limited to three banks, a fact that could give the impact of the episode a relatively short shelf life.


"Those three banks and their experiences have been informing the whole conversation," Sewell said. "As we get deeper into 2024 and those memories start to fade, I wonder if it will feel as immediate as policymakers are looking at these bigger picture issues."

With a proposed cumulative capital increase of 16% across impacted banks, the U.S. version of the Basel III endgame standards is poised to be more stringent than its equivalents in the UK and the Eurozone, which are looking at increases of roughly 3% and 10%, respectively.


Under the Basel Accords, different regulatory jurisdictions are given national discretion to increase or decrease certain components of the framework based on their own needs and preferences. How U.S. regulators calibrate their implementation relative to their counterparts across the Atlantic figures to play a role in the debate over capital requirements.


American banks and their allies say the standards put forth by Washington regulators amounts to "gold-plating" of the international guidelines. They argue the disparities will deepen the longstanding competitive disadvantage U.S. banks have relative to their overseas peers.


In public remarks at the Barclays Global Financial Services Conference in September, JPMorgan CEO Jamie Dimon said the approach taken by the Fed, FDIC and OCC undermines the founding intent of the Basel Committee: to standardize bank regulation around the world.


"What was the goddamn point of Basel in the first place?" Dimon said.


But proponents of the proposed reforms — including academics, consumer advocates and other industry participants — say higher capital requirements could benefit the bottom lines of U.S. banks by improving their credit ratings, thus decreasing their borrowing costs and bettering their positions on derivatives.


Mayra Rodríguez Valladares, managing principal of the financial regulatory consulting firm MRV Associates, said so-called "gold-plated" capital rules have not prevented American banks from outperforming their European peers in terms of stock values, returns on assets and net interest margins. She added that the difference between the regulatory proposals would not be enough to erase the advantage U.S. banks have built over other institutions.


"I don't see this as a reason for American banks to fear that somehow they're going to be overrun by British banks," Rodríguez Valladares said. "It's not like all of a sudden these banks are going to be in a position to come here and increase their presence."


Sean Campbell, chief economist at the large-bank industry group Financial Services Forum, said the disparate regimes will make it more difficult for U.S. banks to serve American customers — primarily businesses — who would like to expand into other jurisdictions.


Campbell also argued that simply because American banks have been able to thrive despite higher capital requirements does not mean they should have to.


"The notion that banks are effectively operating with one hand tied behind their back and they're still doing well, doesn't tell you that it's a good idea to be operating with one hand tied behind your back. That's an illogical argument," he said. "The question is how well would they be doing if they weren't being hamstrung by regulation that is being applied only to U.S. firms and not European ones?"

One area of the reforms where the application of national discretion is most apparent is on capital requirements applied to operational risks.


A focal point of the latest Basel standards was to standardize the treatment of operational risks, rather than the current approach which allows banks to rely on internal models. The committee established risk weights for certain exposures and a method for calculating the capital needed to offset them.


Unlike other jurisdictions, U.S. regulators incorporated this new operational risk framework in full. This equation includes aggregate risk exposures, the size of the bank and an "internal loss multiplier," which uses a bank's average annual operational losses during the trailing 10 years to amplify the amount of capital it must set aside.


In an October speech, Barr defended the approach taken by U.S. regulators.


"Research suggests that banking organizations with higher overall business volume are likely to have exposure to higher operational risk," Barr said. "Further, higher operational losses are associated with higher future operational risk exposure."


To the chagrin of bank advocates, the agencies also established a baseline — or "floor" — multiplier of 1, meaning banks with fewer past operational losses will not see their capital obligations diminished.


The UK's significantly lower proposed capital requirements are explained, in part, by its decision not to include the internal loss multiplier. In its policy statement, the Bank of England asserted that because operational losses are "infrequent but very large," they are not an accurate predictor of future losses. Instead, it subjects all banks to a multiplier of 1.


Chen Xu, a bank regulatory lawyer with Debevoise & Plimpton, said even by regulators' official estimates — which he believes understates the actual impact — the operational components of the proposal are driving "the vast majority" of capital requirement increases.


Xu said the calibration of the requirements would be felt most acutely by banks that rely more heavily on fee-based income than interest-based revenue.


"The methodology is flawed," Xu said. "It's particularly over calibrated with respect to fee- and service-related businesses, things like wealth management, retail brokerage and asset management."


Banks have been crying foul over the calibration of the proposal's capital requirements related to operational risk since this summer. But, the issue rose to prominence in the waning weeks of the year after Fed Gov. Christopher Waller — who cast one of the two dissenting votes against putting the Basel III endgame framework out for public comment — said he would consider supporting a final rule that made changes to operational requirements.


"If there's some willingness to move on operational risk and some other things, there is a possibility that this would be put forth in a revamped way that would be acceptable," Waller said during a November speaking engagement at the American Enterprise Institute.