With a majority of respondents voicing concerns about the Basel III Endgame package or calling for a re-proposal, major changes can be expected to its policy design. Bob Currie examines what the ‘re-proposal’ might look like.
The Basel III Endgame proposal in the US is likely to be substantially revised in response to feedback from market participants, policymakers and other stakeholders.
A possible re-proposal
In a speech delivered to the Brookings Institution on 10 September 2024, Federal Reserve Board (FRB) Vice-chair for Supervision Michael Barr indicated that he will recommend that the FRB makes amendments to the Basel III Endgame and Global Systemically-important Bank (G-SIB) surcharge proposals.
This ‘re-proposal’ will extend to all of the main components of the rule, including credit, market and operational risk.
Vice-chair Barr indicates that banks with assets of between US$100 billion and US$250 billion, which were in scope under the terms of the July 2023 proposal, will no longer be subject to Endgame changes, other than a requirement to recognise unrealised gains and losses on certain securities in their regulatory capital ratios.
Considered in aggregate, Vice-Chair Barr predicts that the ‘re-proposal’ will increase Common Tier 1 capital requirements for G-SIBs by 9%. For large banks that are not classified as G-SIBs, these changes would increase their capital requirements by 3-4% – largely from inclusion of unrealised gains and losses on securities. For the remaining banks falling into scope of the regulation, these changes are expected to increase capital requirements by 0.5%.
He indicates that these revisions are a response to feedback received on the July 2023 proposal and are designed to align Basel capital charges more closely with the risks presented by these banking activities.
For cleared derivatives, Barr will recommend that the Board adjusts capital treatment for client-cleared derivatives by lowering the level of capital that clearing banks are required to hold against the client-facing leg of a client-cleared derivatives transaction. “This change would better reflect the risks of these transactions, which are highly collateralised and subject to netting and daily margin requirements,” says Vice-Chair Barr. “This also would avoid disincentives to client clearing.”
More broadly, Barr suggests that he will recommend changes that enhance banks’ ability to apply internal models for market risk under the Basel regime (see below). He predicts that the re-proposal will offer a multi-year implementation period for the profit and loss attribution tests that are employed to verify that models are working as intended.
This extended transition period will enable banks to gain experience in using the tests, providing time to improve their systems and processes and to address any potential gaps in model performance and data.
Setting up the Endgame
The Basel III Endgame proposals were published by US financial regulators – the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation – in July 2023, introducing significant revisions to the capital requirements applicable to large banking organisations and to banks with significant trading activity.
In the words of these regulatory agencies, the proposal aims to modify large bank capital requirements “to better reflect underlying risks” and “to increase the consistency of how banks measure their risks”.
In doing so, it aims to standardise elements of the capital framework related to credit risk, market risk, operational risk and financial derivatives risk. Additionally, the proposal would require banks to include unrealised gains and losses from certain securities in their capital ratios.
This proposal was circulated for public consultation on 27 July 2023, with respondents asked initially to send their feedback by 30 November 2023. However, this consultation window was subsequently extended until 16 January 2024.
The industry’s response
During the consultation process, more than 350 respondents sent their feedback on the proposal. Law firm Latham & Watkins has evaluated these comment letters and published its summary findings in a February 2024 report, Comments on the Basel III Endgame Proposal: Opposition and Significant Concerns Dominate the Record.
It notes that most commenters reacted negatively to the proposal. More than 97% of respondents called for a re-proposal, or expressed significant concerns with the proposal or its critical aspects, the report concludes.
In evaluating feedback from US policymakers, Latham & Watkins found that opposition to the proposal bridged the political divide, with a “significant majority” of elected officials, both Democrat and Republican, expressing opposition to, or significant concerns with, the proposal. This included 225 of 237 members of Congress and all 66 state and local government representatives that submitted feedback during the consultation period.
On the basis of a quantitative impact survey (QIS), the International Swaps and Derivatives Association (ISDA) and the Securities Industry and Financial Markets Association (SIFMA) warned in their feedback to the US Basel III Endgame and G-SIB Surcharge consultations that the proposed increases in regulatory capital against banks’ trading and clearing activities do not align with the underlying risks associated with these activities.
Implementation of the US Basel III Endgame proposals, they suggest, will make it harder and more costly for banks to provide these services. If banks are pressured to reduce their engagement in these areas, this could impact the liquidity and vibrancy of US capital markets, thereby increasing costs, reducing choice and impairing risk management for market participants and for US businesses more widely.
To evaluate the potential impact of the proposed rule changes, the two associations conducted a QIS with input from eight US G-SIBs. This forecasts that market risk capital would increase by between 73%and 112% , depending on the extent to which banks use internal models.
Under the US Basel III proposal, banks will need to fulfil strict requirements to use internal models for market risk. The 112% upper boundary is calculated for a firm applying the standardised approach to the full portfolio. By making it more difficult to apply internal risk models, firms will be moving closer to that upper boundary.
For credit valuation adjustment (CVA), most banks are currently constrained by the US standardised approach, which includes credit risk and market risk. However, the US Basel III proposal will include operational risk and CVA as part of the expanded risk-based approach (ERBA), which will become the new binding constraint for more US G-SIBs. The CVA is an adjustment to the market price of derivatives and SFTs to take into account the default risk of the counterparty.
SFTs
ISDA and SIFMA have also urged the US Federal Reserve to review its plans to implement a framework for minimum haircut floors for SFTs. The minimum haircut floors framework for SFTs was introduced into the Basel standards in 2017, taking into account a recommendation made by the Financial Stability Board (FSB) to introduce numerical haircut floors for non-centrally cleared SFTs in which secured financing is provided to non-banks against collateral other than government debt.
With respect to SFTs, ISDA and SIFMA estimate that the application of the minimum haircut floor would result in an 18%increase in capital requirements. In contrast, other jurisdictions outside the US, including Canada, the EU, Japan and the UK, have not announced plans to implement minimum haircut floors.
Preliminary reaction to re-proposal plans
Speaking on 25 September 2024 before the Financial Institutions and Monetary Policy Subcommittee of the US House of Representatives Committee on Financial Services, SIFMA CEO Kenneth E Bentsen Jr noted that, under the original Basel III Endgame proposal, the additional capital requirements for derivatives could require banks to pass on additional costs of more than than US$10 billion per annum, while the cost to hedge interest rate risks would be likely to increase by nearly 10 bps. These, he noted, are significant increases that would lead to higher costs for businesses and consumers.
“While Vice Chair Barr did indicate that the capital treatment for the client-facing leg of client-cleared derivatives transactions will be reduced, we continue to believe that these transactions should be excluded altogether from scope of the CVA,” says Bentsen.
SIFMA also argues that treatment of over-the-counter (OTC) derivatives transactions with commercial end-users will need to be more favourable in the final US rule to bring this into line with other major jurisdictions (eg EU markets and the UK) and to make these consistent with longstanding policies designed to facilitate prudent risk management practices for derivatives.
More broadly, Bentsen commends the regulatory agencies for acknowledging the need to make “broad and material revisions” to the Basel III Endgame rule based on their analysis of the data collected after the original proposal was issued and the feedback received through public consultation. “We look forward to providing our comments and analysis on both the re-proposals and QIS once they are released,” he says.
Speaking to the US House Financial Services Subcommittee on Financial Institutions and Monetary Policy, Bentsen welcomed indications that the proposed SFT haircut framework will not be adopted in the US, “given the significant adverse effects on the critical securities borrowing and lending markets that it would have”. Removing this framework, he noted, would also align the US with the approach taken by other major jurisdictions.
With respect to use of internal models, Bentsen commended Vice Chair Barr’s statement that the re-proposal will include changes to facilitate banks’ ability to use internal models for market risk. “Internal models better reflect firms’ risk profiles,” he says. “However, the specifics will matter. In the Fundamental Review of the Trading Book (FRTB) portion of the proposal, adjustments will need to be made to the capital requirements for modellable risk factors (IMCC) and non-modellable risk factors (NMRF) in addition to the P&L loss attribution (PLAT) test to facilitate greater use of internal models approaches”.
Speaking to the same House Financial Services Subcommittee on 25 September 2024, Subcommittee Chairman Andy Barr, Republican Congressman for Kentucky’s 6th district, indicated that the “initial and shockingly under-analysed” July 2023 Basel III Endgame proposal was met with criticisms from across the ideological spectrum and from a wide range of industries and interest groups.
“Before discussing details, I would like to point out that, while we may not agree on everything, there has been good work from both sides of the aisle in this Subcommittee monitoring and overseeing the agencies,” he says.
Chairman Barr indicated in his speech that the proposal was sold partly as a reaction to the March 2023 bank failures and turbulence from interest rate risks. However, in his view, the vast majority of the proposal had nothing to do with that risk. “
While his namesake, Vice Chair Michael Barr, sketched out “limited hints” of what may be coming, “once again these remarks provided numbers without underlying details,” says Chairman Andy Barr. “Vice Chair Barr said the new proposals would be voted on ‘soon’ at the Fed.
*DerivSource will publish a more detailed update for readers, with reaction from key industry participants, when the full text of the expected re-proposal is published. See more regulation coverage here.
