Our Take: financial services regulatory update – July 28, 2023

On July 27th, the Fed, FDIC, and the OCC released their long-awaited proposal to implement the final components of the Basel III agreement, also known as the Basel III endgame. Separately, the Fed also proposed adjustments to the calculation of the capital surcharge for global systemically important banks (G-SIBs). The agencies estimate varied impact across the categories of the Fed’s tailoring framework, with an aggregate increase in RWA by 24% for Category I and II banks and 9% for Category III and IV banks. The proposals include adjustments to the following areas:

• Expanded scope and new requirements.
  • Scope. The proposal confirms that it would apply to banks with over $100 billion in assets.
  • Changes in capital numerator. The proposal would remove the accumulated other comprehensive income (AOCI) opt-out for Category III and IV banks, requiring them to recognize unrealized gains or losses in calculating their regulatory capital. These banks would also be subject to deductions currently only applicable to larger banks (e.g., mortgage servicing assets, deferred tax assets (DTAs), significant investments in the capital of unconsolidated financial institutions) and rules for minority interest.
  • New capital requirements. Banks between $100 and $700 billion would be subject to total loss absorbing capacity (TLAC) requirements, the supplementary leverage ratio (SLR), and the countercyclical capital buffer (CCyB), if activated. Currently these requirements only apply to G-SIBs and/or Category II banks.
• Banks need to calculate RWA under two approaches, subject to an output floor.
  • Dual approach calculation. Banks would be required to calculate RWA amounts under the standardized approach and the “expanded risk-based approach” (the regulators’ term for the proposed Basel III endgame requirements), with the higher of the two being used to set their minimum capital requirements (see Figure 1). Importantly, even in the standardized stack, the new market risk RWA will be applied, thereby increasing capital requirements for the standardized stack at firms with trading exposures.
  • Output floor. The proposal also maintains an output floor that would serve as a lower bound under the expanded risk-based approach for banks that adopt the internal model approach of market risk. If the risk-weighted assets under the expanded risk-based approach were less than the output floor, the output floor would have to be used as the risk-weighted asset amount under the expanded risk based approach.
• Large increase in capital requirements across risk stripes.
  • Market risk changes would drive increased capital requirements for banks with large trading books.
    • New standardized approach applied by default. A new standardized approach must be used by all Category I-IV institutions, and across all asset classes. This is expected to result in a higher market risk capital requirement compared to the existing approaches. 
    • Internal models remain but on a more granular and limited basis. Expected shortfall models would replace value at risk (VaR) models, with heightened requirements for obtaining regulatory approval prior to use. Banks will have to determine the benefit and cost of developing models for the most liquid products (although prohibited for securitization or correlation trading instruments) on a desk-by-desk basis.
    • New banking book and trading book boundary. The proposal provides revised definitions of covered market risk positions with explicit inclusion (e.g., publicly traded equity positions) and exclusion (e.g., debt securities for which the fair value option was elected) of certain product types. This could expand the scope of positions requiring market risk RWA calculations and require banks to develop procedures to accurately identify such positions.
    • Revised market risk scope. All banks with over $100 billion in assets are now required to calculate market risk capital requirements regardless of the size of their trading assets and liabilities. Additionally, other firms (not otherwise in scope) with “significant trading activity” (i.e. with trading assets and liabilities of $5 billion or more or that exceed 10% of total assets) will also be subject to the requirements. The $5 billion threshold is an increase from the previous $1 billion.
  • Credit valuation adjustment (CVA) applies a standardized approach, with no internal models option.
    • Alignment to simulation-based accounting CVA approaches. The proposal would replace the current approaches for measuring capital requirements for changes in the valuation of over-the-counter (OTC) derivative contracts with a standardized approach largely intended to align to common market simulation based approaches to determine accounting CVA. However, firms will need to ensure specific aspects of existing models are aligned to regulatory requirements.
  • Operational risk would be another primary driver of increasing capital requirements for all banks.
    • Shift to standardized approach. The internal models based approach (i.e. the advanced measurement approach) has been removed and replaced with a standardized approach that accounts for a bank’s business volume, activities, and historical operational risk losses.
    • Internal loss multiplier (ILM). The ILM is a component of the standardized operational risk RWA calculation process that adjusts RWA based on a 10 years of operational loss history. Despite the ILM being set at one (eliminating its impact) in the EU and UK, the US proposal would allow the ILM to scale operational risk RWA up if firms have substantial operational loss events in the look back period.
  • The changes to credit risk in the US may not be as beneficial as expected.
    • Gold plating on lending. The proposal would increase risk weights beyond Basel levels (known as gold plating) for a number of material portfolios. For example, the residential mortgage framework now includes loan-to-value (LTV) bands, but the risk weights would be increased by 20 percentage points relative to the Basel framework. Similarly, for retail exposures, risk weights have been increased by 10 percentage points. For corporate exposures, the proposal requires them to be listed on a recognized exchange to be classified as investment grade, which aligns with the Basel framework but deviates from the EU/UK implementation where the listing requirement was excluded.
    • Haircut floors for securities financing transactions (SFTs). For repo-style transactions and eligible margin loans, the proposal includes haircut floors that generally align with the Basel framework but excludes certain transactions where a bank borrows securities for the purposes of meeting a current or anticipated demand, providing some capital relief.
    • No simple transparent and comparable (STC) securitization. The proposal does not include the STC criteria for securitization exposures as included in the Basel framework and also proposed in the EU with some modifications. The Basel STC criteria permitted eligible securitization exposures to receive preferential risk weight treatment and applied more punitive risk weights to non-STC exposures. The proposal would subject all securitization exposures to the more punitive capital treatment.
    • All large banks would use the standardized approach for counterparty credit risk (SA-CCR). All large banks would need to use SA-CCR to calculate exposures for derivatives. Category I and II banks currently use SA-CCR, but today other large banks have the option to use the current exposure method approach for such exposures.
    • Cross-default added to definition of defaulted exposures. The proposal’s classification of defaulted exposures (excluding to a sovereign entity, real estate exposure, a retail exposure, or a policy loan) would look to the performance of the borrower with respect to credit obligations to “any” creditor, whereas the Basel framework does not explicitly call out defaults to “any” exposure. Such exposures will be risk weighted at 150%.
• Stress testing will need to consider both the standardized and the expanded approaches. 
  • Binding constraint approach for stress testing. Banks in Categories I - III of the Fed’s framework would be required to use the capital and RWA approach that is the binding constraint at the start of the projection horizon for capital stress testing. For many banks, the binding constraint is likely to be the expanded risk-based approach. Category IV banks would need to make baseline projections using their binding constraint approach.
• G-SIB surcharge  to use more daily and monthly average data.
  • Daily average input data and cliff effects. The G-SIB surcharge proposal would report and measure certain systemic indicators as an average of daily values over the quarter or average of month-end values rather than only year-end. It would also measure the GSIB surcharge in increments of 10 basis points rather than 50.
  • Adjustments to the interconnectedness component. The proposal would also expand the definition of “financial institution” to include savings and loan holding companies, private equity funds, asset management companies, and exchange-traded funds. This will increase the interconnectedness component of the surcharge.

Comments on both proposals are due by November 30, 2023. As proposed, implementation of Basel III endgame would take effect July 1, 2025 with a three year phase in until June 30, 2028.

Our Take

The proposal would raise capital requirements beyond what was anticipated and implemented globally.

• Most significant increase in capital for the largest banks. G-SIBs would be the most adversely impacted under the proposed expanded risk-based approach, particularly those with large sales and trading businesses.
• Retention of internal models for market risk presents both challenges and opportunities. To meet the proposed standards, banks would need to develop entirely new market risk models with much more granular calculations and will need to obtain regulatory approval before using them. While waiting for this approval, banks would have to utilize the more punitive standardized market risk approach. However, for certain firms the ultimate market risk capital benefit from utilizing internal models may be significant as the output floor constraint is assessed against total expanded risk based capital (with standardized measure for market risk).
• New operational risk impact. With the expanded risk-based approach likely to result in the binding capital ratios for most banks, the new standardized operational risk approach would materially increase capital requirements. Given that the ILM component was set to one in the UK and EU, a similar adjustment to improve competitiveness for US banks would likely be considered as part of the comment process.
• Gold plating will fuel arguments around pushing financing out of the banking sector. There are several provisions that “gold plate” or go beyond the standards implemented in other jurisdictions (e.g., risk weights on residential mortgage, definition of default). These higher capital requirements could push even more activity into the less stringently regulated non-bank finance sector. Some Fed governors have expressed concern about the implications of this shift on financial stability.

The proposal significantly reduces variance between categories in the regulatory tailoring framework.

• Biggest change in requirements for banks with between $100 and $250 billion. These banks were the greatest beneficiaries of the Fed’s 2019 tailoring framework as they were placed in Category IV, which had the most relief from post-crisis requirements. However, the newly proposed changes will essentially collapse the categories with little differentiation in capital requirements between Categories II and IV. While Category III and IV banks have lower increases in RWA through the expanded risk-based approach, the changes to the definition of capital (e.g., removal of AOCI opt out, limits on deferred tax assets, and limits on minority interest) will have a significant impact. Banks will need to analyze their temporary difference DTAs to determine if they will need to haircut the DTAs that are included in CET1.
• New considerations at $100 billion threshold. These changes would also result in a new incentive structure for banks close to $100 billion to either diligently remain below the threshold or to grow substantially enough, including through mergers, to benefit from economies of scale given the increased regulatory cost.

Compliance will be more complicated than just meeting new regulatory capital minimums.

• Each change would need operational adjustments. The proposal introduces a significant number of modifications and refinements that will require banks to adapt their data, calculations, processes, controls, and documentation, putting pressure on all three lines of defense. Category III and IV banks will particularly need to make significant investments to comply with the proposed enhanced risk-based requirements as well as SLR, SA-CCR, and TLAC requirements which currently only apply to the largest banks.
• Models and processes would need to be ready on July 1, 2025. Despite the three year phase-in period to meet capital requirements, banks will need to have their updated models and calculations ready from the effective date and to conduct calculations under both new and old approaches throughout the phase-in period.
• Banks likely to update capital allocation strategies. While banks with shortfalls could raise the necessary capital through earnings and reduced distributions to shareholders, most will seek to optimize their capital allocation strategies for the new approaches. Banks have long been arguing that these efforts will result in reduced lending and trading activity that may not deliver adequate economic returns relative to its capital impact. They are likely to continue to press this point and to push the regulators for evidence-based rationale for higher capital requirements.

What happens now?

• 120 days to digest and comment. While the 120-day comment period is longer than usual, it will still be a tight timeframe for banks to digest the proposal, determine how it affects them, and to organize their advocacy to focus on the areas where they can make the strongest case for relief in the final rule. The lack of initial concessions and multiple dissents by Fed and FDIC board members indicates that there are components of the rule that may well be adjusted before the rule is finalized.

Figure 1: Risk based capital stacks

Source: PwC Analysis

*  Existing standardized approach except derivatives that must use SA-CCR

** SCB will be same across both the stacks and will based off of the constraining approach as of the jump off point for stress testing

*** Expanded Risk Based RWA (stack 2) would be floored at 72.5% of RWA calculated across risk stripes using the same expanded risk based approach but using only standardized measures of the proposed market risk framework

**** For simplicity “adjusted allowance for credit losses not included in tier 2 capital” and “allocated transfer risk reserves” are not included