The global financial crisis (GFC) of 2007-09 demonstrated conclusively the impact that failure of individual banks can have on the stability of the global financial system – a phenomenon known as systemic risk.

In particular, the crisis highlighted the fundamental role of capital adequacy in containing systemic risk. The response in the US was increased capital requirements for large banking organizations to enable them to better absorb losses that threaten to disrupt financial intermediation in the economy. It was also expected that the resulting enhanced resilience of the banking sector would support more stable lending through the economic cycle while reducing the possibility of fresh financial crises and their associated costs.

[Open banking – A global perspective]

These US reforms to the regulatory capital framework were broadly consistent with an initial set of global standards published by the Basel Committee on Banking Supervision (BCBS) that followed the financial crisis. In line with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Act), the Federal Reserve also implemented capital planning and stress testing requirements for large bank holding companies and savings and loan (S&L) holding companies. Additional capital buffer requirements were also imposed to mitigate the financial stability risks posed by US global systemically important banks (G-SIBs), as well as other enhanced prudential standards.

Now, in a further tightening of the capital requirements regime (and informed by the experience since the crisis), the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (Board), and the Federal Deposit Insurance Corporation (FDIC) (collectively referred to as the “agencies”) have issued a Notice of Proposed Rulemaking (NPR) that proposes to modify the capital requirements applicable to banking organizations. These new rules apply to institutions with total assets in excess of $100 billion and their subsidiary depository institutions (“large banking organizations”) and to banking organizations with “significant trading activity.”

[Rates turmoil strikes financial system]

Once again, the requirements under the proposed US rulemaking are consistent with the Basel III reforms issued by the BCBS, more specifically to the “final changes” published by the BCBS in December 2017 and the market risk framework in January 2019. There are, according to the NPR, “variations to reflect specific characteristics of US markets, requirements under US generally accepted accounting principles (GAAP), practices of US banking organizations, and US legal requirements and policy objectives”.

As often is the case, the proposed changes involve elements of “super-equivalence” – essentially being tougher than the reforms published by the BCBS, despite the fact that the US is represented on the BCBS and agreed to what the Committee published (the same is true of the EU and the Bank of England, though not to the same extent as it would appear for the US).

For example, in the case of credit risk the proposal would effectively eliminate the use of banks’ internal models to calculate regulatory capital requirements and in its place apply a simpler, standardized framework. This would overcome a perceived lack of transparency and variability of results associated with internal models, and enhance the ability of supervisors and market participants to make independent assessments of a bank’s capital adequacy, individually and relative to its peers.

[Credit cycle on the turn]

The NPR notes that as the size and complexity of a financial institution increases, there are more opportunities for operational risk issues to emerge. Operational risk exposures have been – and continue to be – a persistent and growing risk for banks, with the proposal stating that the current, models-based approach can “produce estimates that exhibit substantial uncertainty and volatility as well as a lack of transparency and comparability”. To address this, the NPR proposes a simpler, standardized calculation.

The GFC saw banks incur significant losses in their trading books. Banks had long used internal value at risk (VaR) models for these positions, but the crisis highlighted how these models inadequately captured the risks. While the NPR retains banks’ ability to use internal models for measuring market risk, it proposes replacing VaR with an expected shortfall (ES) methodology that better accounts for potential losses. The use of internal models would also be subject to enhanced requirements for model approval and ongoing performance testing.

The NPR also includes a standardized measure for market risk that is risk-sensitive and provides comparability across banking organizations. Banks may elect to use this rather than the models-based approach. Those that do not receive approval to use the models-based measure would be required to use the standardized measure.

Counterparty credit risk (CCR) associated with financial derivatives is dealt with by the introduction of standardized approaches for credit valuation adjustment (CVA) risk. This refers to potential mark-to-market losses on derivatives transactions resulting from the credit risk of the counterparty. During the GFC, CVA risk was a major source of losses on banks’ derivatives portfolios.

The NPR aims to streamline regulatory capital calculations by applying requirements more consistently across large banking organizations. To this end, the applicability of several aspects of the current rules have been expanded to apply to all categories of bank. Significantly, the proposal would include Category III and Category IV banks (generally those with between $100 and $700 billion in total assets) into much of the capital framework already applicable to the very largest banks (Category I), imposing substantial regulatory adjustment costs on those “smaller” organizations. This is likely a response to issues highlighted by the failure of Silicon Valley Bank (SVB) earlier this year.

The impact of the NPR, should it be implemented as proposed, would “vary meaningfully by institution, depending on each banking organization’s activities and risk profile”. Some estimates suggest that it would increase common equity tier 1 (CET1) capital requirements by as much as 16% for holding companies and 9% for insured depository institutions.

According to the FDIC, the majority of banks that would be subject to the proposed rule currently have enough capital to meet the proposed requirements, and large banking organizations identified as having shortfalls currently would be able to achieve compliance through earnings over a short timeframe, even while maintaining their dividends.

The proposed changes would be phased in over a 3-year transition period with any final rule not expected to take effect until July 1, 2025. Taking the effective date and transition period together, the capital requirements under a final rule would not be fully effective until the second half of 2028.

Intuition Know-How has a number of tutorials relevant to the content of this article:

• Basel III – An Introduction

• Basel III – Measurement Approaches
• Basel III – Liquidity & Leverage
• Basel III – Pillar 2 & ICAAP
• Basel III – Pillar 3 & Risk Reporting
• Global Financial Crisis – Causes, Impact, & Legacy
• Dodd-Frank Act
• Credit Risk – Measurement & Capital Requirements
• Credit Risk – Lessons from the Financial Crisis
• Credit Risk Measurement – Capital Calculations
• Operational Risk – An Introduction
• Operational Risk – Measurement & Reporting
• Market Risk – An Introduction
• Market Risk – Measurement
• VaR & Expected Shortfall – An Introduction
• VaR & Expected Shortfall – Measurement
• Counterparty Credit Risk (CCR) – An Introduction
• Counterparty Credit Risk (CCR) – Measurement
• Basel III – Pillar 1 & Capital Adequacy