Bank regulation (for big banks, small banks, community banks, and those banks "too big to fail) is always an ongoing thorn for those who lead banks. Most understand why regulation exists (e.g., protect consumer deposits, ensure adequate liquidity, corral banks' appetite for taking too much risk in lending and trading, and put handcuffs on banks that might jeopardize the existence of a financial system).
Yet the "thorn" for bank leaders (CEOs, particularly, who must (a) understand the arcane rules and (b) ensure their banks remain comfortably in compliance) is that the rules change frequently. Most of the time, they get more complex and onerous. Some senior bankers complain that some rules are irrelevant, don't properly address the risks they aim for, or duplicate other rules. They express their concerns in annual-report presentations, in occasional comments to the media, and to shareholders in quarterly earnings discussions.
Now comes Basel "Endgame," a U.S. proposal of rules, led by U.S. bank regulators, that will increase requirements and make them more complex for banks with assets exceeding $100 billion. Until now, U.S. bank regulators imposed complicated rules, but conveniently simplified them for smaller banks--for banks with assets less than $700 billion and especially for community banks (less than $1 billion in assets).
Basel "Endgame" is the U.S. version of a larger initiative globally. Basel, Switzerland, is the home of the global committee that provides guidance on banking regulation around the world. In the 1970s, sovereign leaders felt it necessary for banks across the world to be governed by a consistent set of rules. Over the decades, there had been Basel I, II, and III (for a moment, there was Basel 2.5 in the wake of the financial crisis). For the past few years, there was constant banter about when Basel IV would follow.
Whenever there is a new banking crisis, one like the crisis we observed in liquidity and funding risks a year ago (the one that led to the disappearance of Silicon Valley and Credit Suisse), you can bet regulators huddle to figure what new regulation is necessary to prevent the next banking-system scare. After a series of bank failures, regulators, politicians and and business-school professors follow with "lessons learned." Lessons learned sometimes are reframed into another round of new rules for financial institutions.
In this case of 2023, the rapid disappearance of reputable banks (because of liquidity issues and deposit run-offs) and the concerns other banks would follow a similar route to insolvency spurred bank supervisors to get going with another round of restrictive regulatory requirements. Last year's first-quarter crisis (First Republic and Signature banks disappeared, too) led to a frightening period about confidence in bank deposits and a market guessing game of what other smaller banks were subject to the same liquidity pressures.
Basel "Endgame" (or Basel "Finalization," which is what it is called in Switzerland) doesn't merely address the risks of lack of liquidity and raging deposit run-offs. It's across the board.
In its basic form, bank regulation is generally categorized by risk forms and by whether the bank is properly managing each of those risk forms: credit risk, market risk, operational risk, and liquidity risk. The first three conventionally require the bank to maintain a minimum amount of what is called loss-absorption capital. (Many investors and risk analysts are familiar with the tiers of capital banks have to comply with: Tier 1, Tier 2, T-LAC, etc.)
Regulators insist shareholders and subordinated-debt investors absorb bank losses before deposits are at risk. That makes sense. They are enjoy the upside of returns when the bank does well. They should suffer first when the bank stumbles through losses.
Liquidity regulation generally requires the bank to have access to cash reserves to meet obligations or deposit withdrawals on any day.
The thousands of pages of Basel III and, in the U.S., Dodd-Frank specify what is required and how banks should compute those requirements.
So while the liquidity-risk upheavals in 2023 spurred bank supervisors to review requirements to ensure those events won't recur anytime soon, it becomes an opportunity to review just about everything.
Basel "Endgame" toughens requirements in all risk forms. More important, where before, the most strenuous regulation applied to the largest U.S. banks (with assets above $700 billion and for those considered "too big to fail" (Globally Significantly Important Banks, GSIBs), "Endgame" requirements encompass more banks (banks with assets above $100 billion).
"Endgame" is currently going through a request-for-comments period, and banks haven't hesitated to express points of view. (The rules would not be fully implemented for another four years.) Many such viewpoints are predictable and common: "Bank regulation discourages us from investing and supporting the community." "Bank regulation is too complex and difficult to compute." "Bank regulation gives non-banks too many advantages in financial markets." "Bank regulation requires unusual costs and investments to comply."
Basel "Finalization" (from the BIS-Switzerland) had hoped to simplify the calculation of some requirements (credit-risk capital and operational-risk capital, e.g.), while still toughening and increasing capital requirements for similar levels of exposure or activity.
(One example is the calculation of a capital charge for "CVA" (Credit Valuation Adjustment), the requirement that banks account for the expected loss from credit risks with their derivatives-trading counterparties. CVA computing may hardly be relevant to small- and medium-size banks, but it would be an obsession at Morgan Stanley and Goldman Sachs, because of the gigantic size of their derivatives trading books. If Morgan Stanley does interest-rate swaps (derivative) with JPMorgan, it has capital requirements to protect itself if JPMorgan deteriorates or if it fails. Today, the amounts computed cannot be done on the back of a napkin.)
Around the U.S. and across the globe over the past two years, with interest rates surging, bank investment portfolios, filled with fixed-income bonds of all kinds, suffered substantial market losses. All banks of all sizes, anywhere, have investment portfolios. They take deposits and invest excess cash into bonds, often government bonds or government-backed bonds. Bond values plummeted sharply in 2022-23, and bank losses in their portfolios have exceeded record levels. The question is how does the bank report the losses--at all times or only when they sell the bonds. That depends.
In the U.S., unless the bank had assets above $700 billion, the unrealized losses in those portfolios (applicable to bonds not yet sold) were are not subtracted from bank equity capital.
Basel "Endgame" wants to put an end to that. The losses on investment portfolios (those classified "available for sale") will reduce capital and make it harder for banks to show they have excess capital, if the bank has assets above $100 billion.
Basel "Endgame," while at it, will force banks not subject to such rules to compute capital requirements for operational risks (the risks of loss from technology, systems, processes, misconduct and cybersecurity) and to include off-balance-sheet risks in maximum-leverage requirements ("supplementary leverage" ratios).
Basel III (the non-U.S. version) always stipulated banks should have capital requirements for operational risks. In the U.S., to date, such a requirement is only applicable to the largest banks. With thousands of branches and assets exceeding $1 trillion and with activities in just about all imaginable types of bank activity, they have obvious operational risks (the risks of power outages, employee misconduct, systems failure, cybersecurity threats, etc.).
It's conceivable going forward a bank with $98 billion in assets might decide to refrain from growth, if only not to be subject to the more restrictive regulatory rules. Many familiar U.S. banks toe the line with assets near $100 billion. A bank considering an acquisition or expansion or planning for loan and deposit growth must now assess the impact of new rules on capital requirements and ongoing capital compliance. (For example, Alabama-based bank Regions Financial has assets totaling about $160 billion. Rules not applicable before would apply going forward.)
In all, some industry analysts and bankers have estimated under the "Endgame" rules, bank capital requirements will increase by more than 15%.
Implementing new rules is not as easy as it appears, especially for large banks. Just tweak the formulae and models that determine what's required, some legislators and supervisors might say. Bankers know to change rules is also to change a business and risk-management mindset--which might be the intent of bank supervisors.
The same banks typically address required capital on an ongoing basis at all levels, for all risks, and for all entities. It's a necessary and routine part of managing the bank, managing the balance sheet, reviewing risks and transactions, reviewing new products and business activity. Bank strategic decisions are made following careful analysis of "allocated capital" and "returns on the same allocated capital." All new deals, new loan portfolios, new products, new investments and new trades are all subject to a capital-allocation review. A loan that could be rationalized before "Endgame," because capital required is less and return on capital is more, may not make sense going forward. A derivatives trade that was economically feasible before might be deemed unprofitable going forward.
In some ways, Basel "Endgame" drafters pat themselves on the back for trying to simplify some rules (like capital required for the risks operational losses), even while imposing slightly requirements for similar levels of risk.
The debates, disagreements and pleas to reduce the regulatory burden have begun. They have been and will be well-defined and passionately explained. Yet in the end, what we've observed the past 15 years or so, bank supervisors usually get most of what they unveil in a new round of rule-making.
Tracy Williams
See also:
JPMorgan Acquires a Failing First Republic, 2023
Silicon Valley's Liquidity and Deposit-Runoff Nightmare, 2023
Banks Subject to the Federal Reserve Stress Test, 2020
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