U.S. banks are breathing a sigh of relief after regulators signaled plans to make major changes to a proposal to increase capital charges on large banks. Even with these revisions, however, the biggest U.S. banks are bracing for the impact of the “Basel III endgame.”
In the wake of the 2008 global financial crisis, regulators increased capital reserve requirements for banks around the world as a means of taking risk out of the global system. New data from Coalition Greenwich shows that banks’ responses to these higher capital charges helped usher in significant improvements in overall capital efficiency from FY2016 to FY2022. Over that period, the average ratio of sales and trading revenue to risk-weighted assets (RWA) for U.S. global systemically important banks (GSIBs) increased approximately 25%, providing a much-needed boost to bank profitability.
“In FY2023, bank sales and trading revenues declined which could be an ominous sign for banks ahead of what are expected to be significant increases in capital charges when the Basel III endgame finally takes effect,” says Minal Chotai, Co-Head of Financial Resources at Coalition Greenwich and author of Basel III Endgame to Drive RWA Inflation, Pose Challenges for U.S. GSIBs. “While repricing is an obvious action for banks, there are several levers they can use to minimize the impact of the new requirements on their returns.”
As the regulatory rules are implemented, several actions that larger U.S. banks can take include:
- Accelerate Execution of Technical Levers: To varying degrees, banks have already pulled a number of technology levers—some involving internal modifications to improve data modeling quality while others tap into external sources, such as outsourcing elements of collateral management program. While a lot of work has been done, banks need to continue, and in cases accelerate, the execution of such programs to minimize the impact of upcoming regulatory changes.
- Reassess and Refine Business Mix: While pulling technical levers serves as a plausible approach to optimizing capital usage, capital savings on a larger scale necessitates permanent and strategic change. For instance, introduction of the CVA capital charge made trading in uncollateralized long-dated derivatives more expensive relative to historical levels. Several banks—predominantly large EU banks—created units to house these assets deemed “non-core” to the banks’ ongoing business operations. Consequently, asset and wealth management benefited as resources were reallocated to the division, given relatively high efficiency ratios and little need for capital.
- Optimize Client-Level Resource Allocation: Senior management should not underestimate the long-term value an optimally run client franchise brings to the fore. While past client revenue produced can inform future growth potential, senior management must consider other performance factors, such as client cost-to-serve and client risk-adjusted returns, among others, when deciding where to allocate scarce resources.
Basel III Endgame to Drive RWA Inflation, Pose Challenges for U.S. GSIBs analyzes steps banks can take to enhance capital efficiency and minimize the negative impact of the expected increases in capital charges from the Basel III endgame.
