Regulators ready to narrow scope, lower capital in Basel III re-proposal

Allison Robbert/Bloomberg

UPDATE: This article adds comments from JPMorgan Chase's chief operating officer and president.

The Federal Reserve is poised to narrow the scope of its controversial regulatory reform proposal from last year and trim the overall capital implication for the banks still affected by it.

Fed Vice Chair for Supervision Michael Barr, in a Tuesday morning speech, detailed the changes he would like to see in a re-proposal of the so-called Basel III endgame. Some of the changes would exclude banks between $100 billion and $250 billion from the requirements and would increase the aggregate capital for the nation's largest banks by 9% instead of 19%, as originally proposed. 

Banks with more than $250 billion of assets that are not deemed global systemically important would see their capital requirements increased by less than 5%.

Barr spared no detail in his remarks, wading into the weeds of his desired tweaks.

"It's a spinach-only speech," Barr said during a question-and-answer session following the address.

Barr said the changes were agreed upon by the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency, though all three agencies still must formally adopt the changes and move to re-propose.

"The broad and material changes to both proposals that I've outlined today would better balance the benefits and costs of capital in light of comments received, and result in a capital framework that appropriately reflects the risks of bank activities and is tiered to the banking sector," Barr said. "They also bring the proposals broadly in line with what other major jurisdictions are doing."

Barr said the Fed will have an open board meeting to discuss the changes soon, adding that he expects his changes would have broad support on the central bank's board of governors, though he declined to project how many of the seven members would vote in favor of the re-proposal.

Banks were still absorbing the implications of the proposed changes on Tuesday morning. Daniel Pinto, chief operating officer and president of JPMorgan Chase, was asked about Barr's comments during an industry conference event that overlapped with Barr's speech. 

Pinto said the topline figure was promising, but the devil is in the details. The treatment of market risk in the initial proposal would not only change capital requirements, it would change the way banks do business, he said.

"So it's not just the overall number, it's the composition of it," Pinto said. "And we have no idea yet what the composition is."

The Basel III endgame is the U.S. implementation of an international accord struck in 2017. The changes are aimed at ensuring banks maintain adequate equity to absorb losses in times of crisis. After having their initial adoption effort scuttled by the COVID-19 pandemic in 2020, the Fed, the FDIC and the OCC drafted a proposal last year and released it for comment in July.

The original proposal applied to all banks with at least $100 billion in assets and would have caused their aggregate capital requirements to increase by 16%. This elicited opposition from the banking sector, including a high-profile advertising campaign and threats of litigation. In response, regulators extended the comment window on the rule change and, ultimately, concluded that significant changes were needed.

If approved, the re-proposal would be issued to the public for comment. The document would only include changes made to the original proposal, but the public would be able to comment on all aspects of the framework.

Barr's changes include adjustments to the treatment of risks related to credit, trading and derivatives, tax credit equity financing and operational risk. He also outlined changes to the global systemically important bank, or GSIB, surcharge proposal that was also rolled out last summer.

In his speech, delivered at the Brookings Institution in Washington, D.C., Barr addressed many of the issues outlined by banks, their lobbying groups and other stakeholders. 

On the topic of operational risk, which includes business process failures such as fraud, cyberattacks and lawsuits, Barr called for dropping the inclusion of historical losses in the calculation of capital requirements. In the original proposed formula, regulators suggested using past losses as a multiplier. 

Barr's changes would also make key adjustments to the treatment of fee income, which was of particular concern to large banks. The re-proposal would measure the fee-based activities based on net income, factoring out noninterest income and expenses, for more consistent measurement of related operational risks. 

Finally, the operational risk framework would be changed to reflect lower capital requirements for investment management activities. Barr said this change reflects the lower relative risks of these activities. 

"The agencies received comments suggesting that some fee-based business lines have incurred meaningfully lower operational losses than other business lines," he said. "We have found evidence that investment management has historically experienced noticeably low operational losses relative to income produced."

Other significant changes include an allowance for banks to use internal models to measure most market risks. A hallmark of the original proposal was the move away from bank devised modeling toward more standardized models established by regulators. Banks have argued that they are uniquely positioned to calculate the risk associated with their own complex trading books. 

"I plan to recommend that we make changes to facilitate banks' ability to use internal models for market risk," Barr said. "For example, the re-proposal will introduce a multiyear implementation period for the profit and loss attribution tests that are used to confirm that models are working as intended."

Barr also called for changes to the treatment of mortgages, noting that the original proposal would have had adverse impact on the ability for banks to lend low-income borrowers. Likewise, he recommends lowering the risk weight for tax credit equity funding structures, something that had been flagged as a threat to certain clean energy incentives. 

Non-GSIB banks affected by the proposal — those with between $250 billion and $700 billion of assets — would see their capital increased primarily because of the treatment of unrealized gains and losses on securities, which would now be included in capital calculations. Barr said this change alone would result in a capital increase between 3% and 4% for this tier of bank, with other parts of the re-proposal adding an additional half percentage point.

Banks with between $100 billion and $250 billion, which would be spared from the broader risk capital requirements in the re-proposal, would still have to reflect unrealized gains and losses into their capital calculations. Barr said this could result in modest increases for these banks.  

Barr said the changes to unrealized losses were the ones most related to the failures of Silicon Valley Bank and two other larger regional banks in the spring of 2023. The rest of the changes, he said, were aimed at addressing trading and derivatives issues that arose more than a decade ago.

"This process began in 2013, and so our proposal that we put forth in 2023 was, in part, a response to the March banking stress, but also … in large part, a response to the global financial crisis," he said. "It's been in train for many, many years and it's really finishing the work that started right after the global financial crisis."

Catherine Leffert contributed to this article.