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US bank regulators are expected to issue a notice of proposed rulemaking (NPR) updating US capital rules, known as Basel III Endgame, this spring, with the final rule likely to come later in the year with an expected effective date of January 1, 2025. Industry participants are preparing for this to be the most consequential change to US banking regulation since the 2010 passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act, as it will have far reaching implications for economic growth, credit availability, market liquidity, and financial stability.
What are the Basel III capital requirements for banks? Basel III Endgame is a suite of rules that will change how much capital firms need to hold against credit, market and operational risk exposures. It is designed to make capital requirements more risk-sensitive while reducing variability of risk-weighted assets (RWA).
While US regulators have stated in the past that a more risk-sensitive approach can be capital neutral, Basel III Endgame is expected to raise aggregate capital requirements substantially.
The primary objective of higher capital requirements is to bolster financial stability by reducing the likelihood of individual bank failures and their subsequent effects on the banking system, broader economy and markets. However, such measures do not come without costs. Increased capital requirements can negatively impact economic growth by raising the cost of lending and reducing the availability of financing for corporations and consumers.
As US bank regulators consider how to implement Basel III Endgame, they should consider two key questions: (1) are the increases in capital and other regulatory reforms that have occurred to date enough to prevent taxpayer-funded bailouts in an economic downturn or period of market turmoil and, (2) if the banking system needs more capital, how much is required?
In order to inform this debate, this article evaluates the literature by regulators, international standard setting bodies and academics that seeks to identify an optimal level of capital. Although the estimates across papers vary widely, the average optimal capital level that the papers suggest is near current levels at firms expected to be subject to Basel III Endgame capital requirements.
1. Post-GFC regulatory reforms
Since the GFC, there has been considerable effort to analyze and examine sources of vulnerability in the financial system and to design regulations that mitigate specific risks. The result of this work has been numerous new regulations and supervisory actions seeking to not only make the financial system resilient in periods of economic and market stress, but also to help safeguard large financial firms so they can continue to provide credit and perform their role as financial intermediaries in periods of pronounced market turmoil. The regulations are also intended to reduce the probability of collapse of a large bank and, if one were to fail, limit contagion. These bank regulatory reforms focus primarily on:
- Increasing the amount and quality of banks’ financial resources;
- Introducing stress testing of financial resources and other forward-looking loss estimation techniques;
- Reducing counterparty exposures and risk in trading activities;
- Creating new supervisory programs to complement new regulatory requirements and enforce compliance with the heightened expectations; and
- Requiring supplemental enhancements to risk management.
1.1 Increasing financial resources
Increasing financial resources at banks has come primarily in the form of requirements for higher levels and quality of capital and liquidity to strengthen resiliency. Capital and liquid assets provide a cushion against unexpected losses and cash outflows, reducing a firm’s risk of failure. Capital requirements for large firms have been increased primarily through the introduction of new capital buffers, such as the G-SIB surcharge and Stress Capital Buffer (SCB), as well as the implementation of the standard and enhanced supplementary leverage ratio. In addition, the introduction of Total Loss Absorbing Capital (TLAC) sought to support the operations of a failing institution and allow for an orderly resolution, if needed. The GFC made clear that the level of both capital and liquidity in the banking sector was insufficient, as firms failed due to a combination of losses eroding capital and the closing of critical funding avenues.
1.2 Stress testing
Stress testing of capital and liquidity is a lynchpin of the post-financial crisis regulatory framework. Stress testing involves assessing capital and liquidity levels by evaluating whether there are sufficient resources to withstand a pronounced stressed macroeconomic environment defined by regulators and the banks themselves. Stress tests are now ingrained into the supervisory framework through prescribed requirements governing the evaluation of a bank’s consolidated operations, including:
- Supervisory capital stress tests that assess capital adequacy through different scenarios under conservative assumptions and determine stressed capital needs;
- Company-run capital stress tests that accompany capital plan submissions and demonstrate capital adequacy through idiosyncratic scenarios that stress a bank’s risk profile;
- Internal liquidity stress tests that model near-term funding needs and inform the buffer required to meet net stressed cash flows across a 30-day time horizon.
Each of these components has necessitated significant investment by banks in model development as well as an extensive set of processes for identifying and measuring the material risks stemming from their strategy and operations.
1.3 Reducing counterparty and trading risks
Reducing counterparty and trading risks is an important focus of post-crisis reforms to limit systemic risk and financial contagion. To reduce the extent of risk transmission, regulatory guardrails place limits on aggregate exposures to counterparties. In order to limit risk stemming from trading activities, the Volcker Rule banned proprietary trading for certain products.
- Central clearing of and margin requirements for non-cleared derivatives aim to reduce risk by addressing the operational complexity created by a lack of standardization for swap contracts and lack of standard approaches for raising margin. Regulators have mandated the clearing of swaps through centralized counterparties (CCPs), and implemented standardized margin requirements for non-cleared OTC derivatives.
- Single Counterparty Credit Limits (SCCL) reduce the risk of contagion between financial institutions by establishing limits on the amount of credit exposure a US or foreign holding company can have to an unaffiliated entity.
- Volcker Rule prohibits banking entities from engaging in proprietary trading or investing in or sponsoring hedge funds or private equity funds. Large firms are required to employ an extensive compliance program to demonstrate the separation of banking and trading activities.
1.4 Supervisory programs
Supervisory programs have complemented the implementation of new capital requirements with two explicit goals : (1) enhance the resiliency of a firm to lower the probability of its failure and (2) reduce the impact on the financial system and the broader economy in the event of a firm’s failure or material weakness. Size and the nature of exposures determine the scope of a bank’s participation in horizontal examinations such as:
- Dodd-Frank Act Stress Test (DFAST) and Capital Analysis and Review (CCAR) evaluate large firms’ capabilities in capital planning, including an evaluation of their ability to identify risks, incorporate those risks into a nine-quarter forecasting scenario, and measure those risks by modeling revenue, loss and capital levels in those scenarios, net of capital actions. In addition, regulators evaluate the quality of board and management oversight of this capital planning process.
- Comprehensive Liquidity Assessment and Review (CLAR) is a firm-specific liquidity evaluation that analyzes liquidity risk management practices and resiliency under normal and stressed conditions. CLAR includes an evaluation of a firm’s internal liquidity stress testing capabilities, liquidity position, and liquidity risk management practices.
- Title I Resolution Planning exams are joint assessments by the Federal Reserve and Federal Deposit Insurance Corporation (FDIC) that assess how an institution can be unwound in an orderly manner without undermining financial stability. These plans must incorporate consideration of various areas of enterprise risk management such as capital and liquidity allocation, in addition to other considerations that relate to the firm’s governance, operations, and legal structure. The Federal Reserve also requires G-SIBs to produce recovery plans that include a set of actions that can be taken in a timely manner to reduce the probability of bankruptcy and insolvency.
In addition to supervisory feedback, these exams often include a publication or disclosure of planning strategies, methodologies and relevant metrics for the benefit of the public. The transparency of post-GFC supervision, and its associated disclosure requirements, have a role in reducing financial system risk by bolstering confidence in US G-SIBs.
1.5 Supplemental enhancements to risk management
Supplemental enhancements to risk management include areas where additional requirements and supervisory guidance have sought to enhance risk management, governance, identification, and measurement. In some instances, supervisory guidance has sought to limit the level of risk taking related to certain products, such as restrictions on underwriting criteria. Supervisory expectations have reinforced the importance of maintaining effective credit risk management policies and procedures.
Other enhancements include heightened requirements and expectations that the board of directors is effective in overseeing the risk management capabilities of the bank. As approvers of a bank’s risk appetite and business strategy, regulation requires large bank boards to have a dedicated risk committee to directly and deliberately support the effectiveness and independence of risk management. These enhancements reinforce the importance of having an effective risk management culture throughout individual banks.
2. Literature review
For all the complexity of existing and future banking regulations, there is a simple question at the heart of the issue: what level of bank capital is sufficient to provide a substantial margin of safety but is not so high that it limits economic growth, lending and financial market activity?
Answering this question can be daunting given its technical nature and the vast amount of literature written on the subject. This article identifies and analyzes important papers in this field to inform stakeholders of the marginal benefits and costs of increased capital requirements.
The key papers employ different approaches and consider various factors. As a result, they have highly varied estimates of optimal capital levels.
2.1 Cost-benefit framework
The majority of the literature evaluates optimal capital levels by examining the trade-off between the marginal benefit of higher capital in promoting financial stability and the marginal cost in terms of its potential impact on economic growth. Higher capital levels promote financial stability by increasing the loss-absorbing capacity of banks, reducing the likelihood of bank failures and systemic crises. However, they can also create a drag on growth by raising the cost of credit and potentially limiting the availability of loans, which may reduce investment and economic expansion.
2.2 Results
Despite the variation in estimates across key papers, a central tendency emerges when assessing the midpoint of the range for each study. By selecting the midpoint of the paper ranges and excluding Elenev (2021), the optimal capital range is 12-19.5%, with an average of 15.5%. This figure aligns closely with the actual average tier 1 bank capital ratios of 15.5% and 15.2%, as of the fourth quarter of 2021 and 2022, respectively, for bank holding companies that are expected to be subject to Basel III Endgame capital requirements.
Most of the papers analyze tier 1 capital rather than CET1 due to the latter’s introduction in 2015 and the need to have a longer time series for model calibration. Nonetheless, an implied optimal CET1 ratio can be implied from the studies, which is estimated to be 13.8%. Here, again, this figure aligns with the actual average bank CET1 ratio as of year-end 2021 and 2022 of 13.7% and 13.2%, respectively.
Although optimal bank capital ratios and actual recent ratios are both above current regulatory capital requirements, banks tend to maintain capital buffers above regulatory mandated minimum levels to prevent breaches of regulatory requirements and to accommodate their risk profile and capital strategy, which are determined through internal analysis.
The Figure below provides an overview of the results across the select papers that publish an optimal capital estimate and a comparison between the average of the results and current capital ratios, respectively:
2.3 Limitations
While many of the examined papers attempt to account for some of the post-GFC regulatory reforms that were implemented to reduce risk in the financial system, none of the papers fully attempt to answer a more holistic question: what is the cost/benefit outcome when one considers the combined effect of the entire spectrum of post-GFC regulatory reforms, which include
- The increase in financial resources at large US banks, including TLAC and liquidity, aim to reduce risk in the financial system by providing a cushion in adverse environments, reducing an individual bank’s risk of failure and therefore, strengthening the system overall.
- The implementation of stress testing of capital and liquidity provides a risk-based measure of financial resource needs in a period of stress, enhances the transparency of bank risk through regulatory reporting, and necessitates significant investment by banks in their risk management processes. As a result, these tests reduce an individual bank’s risk of failure and therefore strengthen the system overall. In addition, capital stress tests are expected to achieve a higher degree of risk sensitivity than the standard Basel risk weights.
- Reforms to reduce counterparty and trading risk, which introduced margin requirements for non-cleared derivatives, single counterparty credit limits and restrictions on proprietary trading, reduce the contagion risk of the impact of single counterparty defaults spreading throughout the economy and the level of risk taking on firms’ trading desks.
- Supervisory programs evaluate large banks’ capital planning and risk management capabilities and their results, building trust within the financial system. In addition, supervision supports adequate resolution planning, which enhances banks’ ability to unwind in a bankruptcy event without destabilizing the financial system, reducing the loss to macroeconomic output from bank failures.
- Supplemental enhancements to risk management, including heightened risk management requirements for specific products, the role of directors and enterprise risk management, have generally reinforced the importance of having an effective risk management culture throughout individual banks.
2.4 Conclusion
Overall, the existing body of literature on optimal capital levels is vast, and conclusions regarding what is optimal vary due to differences in approach and assumptions. Therefore, when policymakers consider increases in capital levels that could stem from the implementation of Basel III Endgame, it is important to not only examine the optimal levels of capital discussed in the literature but also to consider the limitations of the analysis presented, such as the partial inclusion of post-crisis regulatory reforms and the complex interactions between bank capital requirements, the size of the non-bank financing sector, the cost of credit and financial stability.
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