Our Take Special Edition: Basel III Endgame

On July 27th, the Fed, FDIC, and OCC released their long-awaited proposal to implement the final components of the Basel III agreement, also known as Basel III endgame. Separately, the Fed also proposed adjustments to the calculation of the capital surcharge for global systemically important banks (G-SIBs) and extensive amendments to the Systemic Risk Report (FR Y-15).

The early headline from the proposal was that its “expanded risk-based approach” for calculating risk-weighted assets (RWA) would result in increased capital requirements. Broadly, the regulatory 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 proposal would effectively undo capital rule tailoring across the four categories primarily by aligning the definition of capital for Category III and IV banks to the stricter construction currently applied to Category I and II banks. The change in the capital definition creates a cumulative impact beyond the headline 9% increase in RWA for Category III and IV banks.

Behind these numbers, closer analysis of the two proposals yields numerous changes that would not only impact banks’ capital requirements but also impose significant operational complexity and present strategic implications for their activities, products and services in light of changing capital costs. We discuss these impacts in more detail across the following areas:

Operational risk standardized approach would increase RWA by $2 trillion
Market risk RWA would rise by approximately 75% across all banks
Credit risk diverges from international standards and adds significant complexity
Tailoring of capital requirements substantially reversed for banks below $700 billion
Banks need to calculate capital under two approaches
Significant operational changes are needed to address governance, data and stress testing
G-SIB surcharge changes would increase capital requirements by $13 billion
Several foreign banks would be elevated to Category II

While the proposals are open for comment until November 30, 2023, it will still be a tight timeframe for banks to digest the proposals, determine how it affects them, and organize their comments to focus on areas where they can make the strongest case for relief in the final rules. The lack of initial concessions and multiple dissents by Fed and FDIC board members indicate there are components of Basel III endgame that may well be adjusted before the rule is finalized.

The regulatory agencies expect to finalize the proposals with enough time to take effect on July 1, 2025 and have a three-year phase in of capital ratio impact until June 30, 2028. However, banks may still find it challenging to complete the necessary transformation programs to prepare their updated RWA calculation approaches by 2025.

Basel III endgame is a significant regulatory capital overhaul. Banks should be looking at this beyond simply a compliance exercise in calculating numbers as it will have far-reaching implications to their capital management, business strategy and operations.

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Operational risk SA could increase RWA by $2 trillion

The proposal replaces the current internal models based approach (i.e. the advanced measurement approach) with a new standardized approach (SA) for operational risk that is partially aligned to the Basel framework. The proposed standardized operational risk RWA formula has two main components:

Business indicator (BI): The BI has a complicated formula with inputs that function as a proxy for size by adding together the main components of revenue; see Appendix A for the complete formula
Internal loss multiplier (ILM): The ILM is a function that increases RWA for firms with substantial historical operational risk losses.

Currently, there is no operational risk RWA in the U.S. standardized approach. Although the proposal suggests that calculating operational risk RWA using the SA would decrease by 18% for Category I and II banks versus the current advanced approach, the current advanced approach is generally not a binding constraint for these firms. Since the proposed expanded risk-based approach would be the binding constraint for most firms, operational risk would materially add to banks capital requirements, whether they are currently advanced approach banks or not, with total RWA increasing by $2 trillion, according to Fed Governor Christopher Waller. Based on the RWA estimates provided in the proposal, the operational risk SA would result in 78% RWA inflation for Category I and II banks and 118% total for Category III and IV banks when compared to total RWA under the current standardized approach.

In the Basel framework, the ILM was intended to introduce a risk-based element to the formula to scale up or down operational risk RWA based on a bank’s actual loss history. The EU and UK decided to eliminate the impact of the ILM by setting its value to one, meaning there is no benefit to having lower operational risk loss history, but no penalty either if historical losses are high. The U.S. proposal instead floors the ILM at one, thereby allowing the BI component to set capital for firms with lower loss histories and adding a penalty for firms with high historical operational losses. By flooring the ILM at one, operational risk RWA becomes a capital charge on size alone for firms with limited operational risk loss histories. A charge on size alone has substantial overlap with the G-SIB surcharge, which is specifically designed to create a capital charge for size, complexity and interconnectedness.

The United States is unique in that it is the only jurisdiction to have an SCB that is calculated as a function of supervisory-run capital stress testing models. The Fed’s stress test models project around $200 billion of operational risk losses, meaning that banks participating in the stress tests already hold capital for operational risk. Consequently the proposed changes to operational risk RWA calculation would make the United States the only jurisdiction that is requiring firms to capitalize for operational risk in both the numerator and denominator of the capital ratio, potentially doubling the total amount of operational risk capital required.

Market risk RWA would rise by approximately 75% across all banks

The proposal expands the scope of market risk capital requirements to all Category I through IV banks and introduces a new framework for standardized market risk capital that all in-scope firms will need to implement, which is expected to result in higher market risk capital requirements. In addition, market risk is the only risk stripe for which the proposal would allow the continued use of internal models, but it would subject internal models approach (IMA) trading desks to enhanced supervisory standards, including pre-approval of models by the regulatory agencies.

Expanded market risk scope

The proposal expands the scope for market risk RWA requirements to all Category I through IV banks. Many of these banks were already captured by the current market risk scope (which currently includes those with aggregate trading assets and liabilities over $1 billion or 10% of total assets); however, we estimate an additional 10 banks would be included due to the new Category I through IV bank requirements. For those firms outside of Category I through IV, the aggregate trading assets and liabilities threshold is proposed to increase to $5 billion, which could result in a handful of banks no longer being required to consider market risk capital RWA.

New risk-based SA

The proposal introduces a new risk sensitivity-based SA for calculating market risk RWA that is expected to result in a higher market risk capital requirement (approximately 70-75% increase based on analysis provided in the proposal) as compared to current approaches. The new SA consists of three main components:

While most banks typically have the ability to generate sensitivities for trading desk positions, banks would need to update their calculations to align with the specific risk factors required under the sensitivities-based method. They would need to assess whether refinements to data and modelling approaches across different front office trading desks and risk systems are needed to enable aggregation of sensitivity calculations. Documentation, model owner and process testing, and model validation procedures would also need enhancements to demonstrate consistency across these sensitivities. In addition, the proposal requires banks to conduct trading desk level daily monitoring using a set of prescribed risk metrics (e.g., trading limits, risk factor sensitivities, transaction volumes), which may require additional granularity in the risk measures generated, and evidence of the operation of those controls.

The proposal replaces value at risk (VaR) measures with an expected shortfall (ES) measure in the IMA to better capture tail losses. For each individual trading desk for which IMA may be applied, banks would have to demonstrate the availability of reliable market data typically only available for more liquid markets, robust ongoing monitoring and backtesting procedures, as well as additional policies and controls beyond those required for the SA. Critically, banks would need to complete and evidence all aspects of the requirements for individual trading desk-level applications, and consider the timelines required to prepare and submit this information in order to apply for regulatory approval, which must be obtained prior to use of the IMA. For those firms that elect to apply for IMA on certain desks, the capital benefit may be significant relative to standardized approaches, especially since the capital benefit is unlikely to be constrained by the output floor since the floor is assessed on the total expanded risk-based capital (as described in more detail below). In evaluating whether to apply for IMA on selected trading desks, banks should consider a combination of “pull” factors, such as the capital benefits, and “push” factors, such as whether there are regulatory expectations for those firms with the most material market risks to demonstrate the ability to meet the more robust risk management capabilities inherent in IMA.

The proposal provides revised definitions of covered market risk positions with explicit inclusion (e.g., unrestricted, publicly-traded equity positions) and exclusion (e.g., debt securities for which the fair value option was elected, and associated hedges) of certain product types. It also specifies the eligibility requirements for internal risk transfers between a banking unit and a trading desk. Banks would need to conduct a thorough inventory assessment of potential covered (and excluded) positions and hedges recognized through internal risk transfers to identify their market risk RWA exposure. Classification of positions within the banking or trading book effectively cements the capital treatment of such positions, as subsequent recategorization would trigger a compensatory capital add-on to offset any potential capital benefit that may appear to arise.

The proposal also introduces the concept of a trading desk, a unit of organization aligned to how banks execute transactions in covered positions. It would require a bank to structure a trading desk pursuant to a well-defined business strategy and include appropriate documentation of its permitted activities, risk factors, as well as trading and hedging limits and strategies.
Banks should assess to what extent their current trading desk structure may need to be revised to comply with the new requirements, including whether existing policies, procedures and controls sufficiently address regulatory expectations. They should also assess whether existing “trading desk” determinations to meet other regulations are consistent or whether revisions would be required to create coherent organization of trading desks that can serve multiple requirements concurrently. For example, although the proposal defines trading desk "in a manner generally consistent with the Volcker Rule," further segmentation may be required to address the more prescriptive granularity of risk sensitivities required under the proposal.

The proposal would replace the current approaches for measuring capital requirements for over-the counter derivatives (OTC) counterparty credit risk exposures with two new approaches:

Basic approach (BA-CVA): Based on the exposures at default for covered derivatives positions, the BA-CVA applies standardized formulas with supervisory risk weights based on the sector of each counterparty.
Standardized approach (SA-CVA): Applies a risk sensitivity-based approach similar to that applied under the market risk SA methodology but with less granular risk factors and risk buckets. Similar to the standardized approach to market risk, the proposal has detailed requirements for how the sensitivities are to be calculated. Banks would be required to meet additional criteria for SA-CVA.

SA-CVA recognizes hedge benefits from both counterparty credit spread hedging and exposure hedging, whereas BA-CVA only allows for partial recognition of credit spread hedges and does not allow for recognition of exposure hedges. Given the nature of derivative portfolios at most Category II through IV banks and the lack of observable credit default swap spreads for the counterparties to most of the banks’ non-cleared derivatives, the ability to recognize exposure hedges may be a significant benefit.

Typically, larger banks already evaluate accounting CVA using simulation-based approaches similar to those required under SA-CVA. Over the years, a number of banks in the US (and globally) have continued to evolve their accounting CVA methodologies to more closely align to regulatory expectations. An example is considering CVA to be a function solely of counterparty default and not contingent on the bank’s survival. As a result, transition to SA-CVA for most in-scope banks would likely require enhancements to existing tools and models tools rather than requiring implementation of entirely new frameworks. However, banks would need to evaluate the level of effort and timeline required to make any necessary enhancements to existing documentation and testing before applying for regulatory approval, which must be obtained prior to use of SA-CVA.

Credit risk diverges from international standards and adds significant complexity

The proposal would replace the current internal models-based calculation of credit RWA with the expanded risk-based approach. It would also add more granular counterparty types with distinct risk-weighting, expand data requirements and increase operational complexity. Credit1 RWA is generally expected to decline versus current standardized U.S. rules, but the proposal deviates from the Basel committee framework as well as implementations in other jurisdictions, creating potential competitiveness concerns for U.S. banks. The changes in the credit RWA calculator processes are pervasive, covering almost all exposure types, and therefore would require banks to make significant enhancements to current operational processes, data, controls, calculation logic, systems, and aggregation and reporting capabilities.

The proposal would increase risk weights beyond levels outlined in the original 2017 Basel framework for a number of material portfolios, such as risk weights for residential mortgage LTV bands that would increase by 20 percentage points. Moreover, the rules would be significantly more complex to implement, requiring banks to reevaluate existing exposures. For example, under the current framework, residential mortgages that are prudently underwritten have a 50% risk weight, but banks would need to review their existing loans to determine whether they factored cash flow from the property (e.g., rent) into the underwriting decision. Such loans would garner 10-35% higher risk weights depending on the LTV band.

For retail exposures (e.g., cards, revolvers, overdrafts, term loans, leases), risk weights would increase by 10 percentage points relative to the Basel framework. The proposal introduces retail as a new exposure category with multiple designations: regulatory retail, transactors, and other retail. Regulatory retail includes loans to a small or medium-sized entity (SME) that meet the regulatory retail definition, and imposes a concentration limit of $1 million to each borrower and its affiliates, requiring exposure aggregation across retail products. Exposures exceeding $1 million would fall into the “other retail” category and receive a 110% risk weight (SME at 100%). There is also a granularity criterion of 0.2% of total regulatory retail exposure that for all intents and purposes would only be applicable to firms with less than $500 million of total regulatory retail exposure since the $1 million limit would already be tripped above that total.

For corporate exposures, in line with the Basel framework, the proposal includes a benefit for IG exposures (based solely on banks’ internal ratings) with a risk weight of 65% compared to 100% under the current U.S. rules. However, in order for the IG risk weights to be applied, the proposal would also require the obligor to have securities listed on a recognized exchange. While this aligns with the Basel framework, it deviates from the EU and UK implementation where the listing requirement was excluded. The proposed formulation would favor public companies over private companies, given that the better capital treatment would allow banks to price public company credit more competitively.

The listing requirement would also result in a new test for IG corporate debt as “financial collateral,” which could result in the elimination of the credit risk mitigation benefit for some collateral that was previously recognized. For example, corporate debt securities that were rated IG may not be considered financial collateral if the issuing entity (or its parents) does not have securities listed on a recognized exchange.

For repo-style transactions and eligible margin loans, the proposal generally aligns with the Basel framework and includes haircut floors for exposures to “unregulated financial institutions” (UFI) that are not centrally cleared. The proposal allows one additional exemption beyond the Basel framework for transactions where a bank borrows securities for the purpose of meeting a current or anticipated near-term demand (and has sufficient documentation to that effect). Unlike the EU and UK where the haircut floors were excluded entirely, these exemptions could theoretically include a large portion of transactions for some broker dealers, but operational complexities may limit the benefit. New procedures, controls, data and documentation would be needed to establish which transactions fall within the exemptions. Failure to either meet the netting set haircut floor or identify and document transactions that meet one of the exemptions would result in banks having to treat these exposures as unsecured transactions. Moreover, for many securities borrowing and lending netting sets, it is common to transact baskets of securities making it very difficult to separate out transactions at the individual security level. In practice, this would force banks to collect more collateral from UFIs to avoid higher capital charges.

The proposal does not include the STC securitization criteria that was included in the Basel framework and also proposed in the EU with some modifications. The STC criteria help mitigate uncertainty related to asset risk, structural risk, governance and operational risk in securitization structures, thereby permitting eligible securitization exposures to receive preferential risk weight treatment (as low as 10% on eligible senior tranches), while non-STC exposures get more punitive risk weights. The proposal would subject all securitization exposures to non-STC treatment, referred to as the securitization standardized approach (SEC-SA). It would also reduce the risk weight floor to 15% compared to the current 20%, which would provide a capital benefit for senior tranches with high levels of credit enhancement. The proposal also excludes carve outs for synthetic securitizations, indicating that obtaining synthetic securitization treatment from regulators would continue to be a challenge in the United States.

The proposal’s defaulted exposures classification indicates that borrowers in a lender’s portfolio who are in default to “any” other creditor (excluding sovereign, retail, real estate, policy loans, or counterparty credit risk) would trigger defaulted risk weight treatment. This deviates from the Basel framework which does not explicitly call out defaults to “any” exposure. This modification presents a significant challenge in identifying defaulted borrowers, as the mechanisms of identification and notification of default to other creditors are not clear and do not exist today.

The proposal would remove the simple modified look-through approach (SMLTA) for banks’ equity in investment funds, forcing banks to apply the most punitive 1250% risk weight where a high level of transparency to look through to underlying positions is not available. In the SMLTA, a bank assigns the most punitive risk weight of the positions of the fund. Although SMLTA was relatively more punitive than the two other available approaches for funds – i.e. alternate modified look-through approach (AMLTA) or full look through FLTA (both of which require having visibility into what the fund is investing in) – SMLTA would have still been more beneficial than applying the flat 1250% risk weight, which is the risk weight banks will now need to use if the requirements for AMLTA and FLTA cannot be met. The proposal also modifies AMLTA and FLTA to include off-balance sheet exposures held by an investment fund, the counterparty credit risk and CVA risk of any underlying derivatives held by the investment fund, and the investment fund’s leverage. As a result, seed capital and other fund investing in all but the most liquid and price observable space would become more expensive.

The proposal would eliminate the NSEI from the current simple risk-weight approach (SRWA) under which equity exposures up to 10% of a bank’s total capital get a preferential risk weight of 100%. Despite there also being no separate carve out for NSEI in the Basel framework, this change from the current U.S. rules would have a material impact on equity RWA as the exposures within the 10% range would have a risk weight of either 250% for public equity or 400% for private equity.

Under the proposal, Category III and IV banks would no longer have the option to use the current exposure method (CEM) and would need to implement SA-CCR, adding significant implementation complexity.

_{1 The proposal includes equity risk carved out as a separate category in the expanded approach}

Tailoring of capital requirements substantially reversed for banks below $700 billion

In addition to including Category III and IV banks in the scope of the change to calculating RWA, the proposal would require them to apply some of the stringent requirements that currently only apply to Category I and II banks, effectively merging the four categories when it comes to capital requirements. Changes to capital deductions and inclusions for Category III and IV banks would be operationally challenging to implement and leave these banks with lower available capital.

The proposal would remove the ability for Category III and IV banks to opt-out of recognizing unrealized gains and losses on available-for-sale securities (AFS) in calculating their regulatory capital through AOCI. This means unrealized AFS portfolio gains and losses would increase or decrease capital levels.

Category III and IV banks are currently required to deduct mortgage servicing assets (MSA), temporary difference deferred tax assets (DTA) that they could not realize through net operating loss carrybacks, and significant investments in the capital of unconsolidated financial institutions in the form of common stock (collectively, threshold items) that exceed 25% of the common equity tier 1 (CET1).2 The proposal would subject these banks to the more punitive deduction requirements of Category I and II banks that are required to deduct first on individual basis the threshold items that are over 10% CET1.2 Any amount of the threshold items that is not deducted is then aggregated and any amount over 15% of CET1 capital is deducted from CET1.2

Category III and IV banks would also be subject to Category I and II treatment for “significant investments in the capital of unconsolidated financial institutions that are not in the form of common stock” and “non-significant investments in the capital of unconsolidated financial institutions,” where they would be required to deduct the entire amount or deduct amounts over 10% of its CET1, respectively. These changes would increase these banks’ CET1 deductions and in effect reduce their available CET1 capital. They would also need to source data attributes to segregate investments in the capital of unconsolidated financial institutions depending on whether they are significant and/or in the form of common stock.

Currently, Category III and IV banks are allowed to include eligible minority interests up to 10% of their capital.² The relatively simple approach would be replaced with a more complex approach that is currently only applicable to Category I and II banks, where among other requirements, banks must look to the capital requirement of their subsidiaries to calculate the amount of minority interest. Category III and IV banks would need to source additional data from their subsidiaries, especially those in other countries with different supervisory standards.

Under current requirements, Category III banks may use SA-CCR or the CEM to calculate derivatives exposures. The proposal would require all banks to use SA-CCR for calculating their derivatives exposures, which could impact banks’ exposure capacity to some of their largest counterparties. This would likely only be an incremental lift as all large banks would already be required to adopt SA-CCR under the new expanded framework.

_{2 Minus certain adjustments and deductions}

Banks need to calculate capital under two approaches

Under the proposal, banks would have to calculate RWA under multiple approaches in order to assess the Collins and output floors.³ This is operationally complex, and the SA and output floor are unlikely to create a binding constraint.

Dual calculations required

Banks would be required to calculate RWA under the SA and the expanded risk-based approach. The SA remains largely unchanged except that all large banks must use the revised framework for market risk and Category III and IV must use SA-CCR for derivatives exposures. The SA would also continue to impose the Collins floor, requiring banks to be bound by the higher of the two approaches.

Output floor would likely be irrelevant for most banks

The proposal introduces an output floor that limits the benefit a bank may receive by using IMA for calculating market risk RWA. Although the output floor is set at the same level as in the Basel framework, it may not constrain banks in the same way in the United States as the Basel framework allows usage of the IMA under all risk stripes, while the United States only allows its usage under market risk thereby limiting the degree to which the floor can constrain the capital benefit.

_{3 The Collins Amendment requires that “generally applicable” risk-based capital requirements serve as a floor for banking institutions’ regulatory capital. In their implementation of the Basel III capital rules, US regulators specified that capital requirements calculated under the SA would serve as the Amendment’s mandated floor.}

Significant implementation challenges

Implementing Basel III endgame would require large-scale efforts and coordination between functions as the proposal adds completely new calculations and requirements.

Under the proposal, banks would need to project capital ratios under their company run stress test (for Category I-III banks) and under the baseline scenario (for all banks) using the approach that is binding as of the start of the projection horizon (i.e. December 31st). For most banks, the binding constraint would likely be the expanded approach. Therefore, banks would be required to enhance their stress testing systems to apply the new RWA rules and add granularity to existing models in order to support the new calculation requirements (e.g., project the distribution of transactor and revolvers for credit card exposures, distribution of investment grade and non-investment grade corporate loans).

Banks could have substantial volatility in their capital requirements during the proposed phase-in due to the timing of SCB determination. Category I through IV banks generally receive their SCBs by June 30th, and in June 2025 that SCB would be based on the current standardized RWA framework. Since the SCB is provided on a percentage of CET1 capital ratio, when the level of RWA increases due to the proposed rule, the dollar amount of the SCB would increase proportionately to RWA. The volatility in capital ratios is likely not intended, and there are various options for the regulators to adjust the final rule to address this concern.

Banks would need to set up a well-defined governance framework to navigate through their compliance journey which should include:

An identified function to own the overall implementation, which could either be through a single function or a shared responsibility based on the bank’s size and complexity
Senior management oversight for implementation, issue escalation, and strategic decision making
An interpretation governance forum to vet interpretations and implementation decisions as well as an audit trail for key assumptions, decision rationale and signoffs
Establishment of processes and controls for data sourcing, calculations and reporting

The proposal introduces a credit risk framework that is risk sensitive, an operational risk framework that looks at historical loss data and a market risk framework that requires active monitoring. Data requirements to comply with these new frameworks are immense. Even banks who were subject to advanced approaches, which was more data intensive than standardized approaches, would need a significant uplift in terms of new data sourcing. Banks generally would be able to break their data requirements into three buckets:

Existing data attributes used in current calculations (e.g., exposures to sovereigns, CRC rating);
New data attributes that may be (1) available in other systems or (2) sourced with moderate level of effort (e.g., aggregated exposure to a single retail borrower, Banking/Trading indicator, Ops loss history, attributes to calculate BIC in ops risk framework); and
New data attributes that are not available in other systems or would need significant effort to source (e.g., cash flow dependence of residential mortgage, for SFT assessment of how the counterparty is reinvesting its cash to determine applicability of haircut floor).

Data will be the foundation of Basel III endgame implementation and all banks would need to set up dedicated work streams for data discovery and sourcing. Where new sources of data are required, banks will need to evaluate whether they are sufficient to support regulatory reporting and develop enhancement plans as needed.

G-SIB surcharges are expected to rise

The Fed separately proposed amendments to the G-SIB surcharge methodology and Systemic Risk Report (FR Y-15) that would increase capital requirements for G-SIBs. These changes would further drive firms to re-evaluate their business strategies in light of incremental capital burdens as well as operational and compliance complexity.

Higher G-SIB surcharges would be driven by the inclusion of derivatives in the cross jurisdictional claims and liabilities, changes to measurement of certain indicators as daily or monthly averages and other revisions to the systemic indicators. The regulators predict an increase of 13 basis points on average across G-SIBs with an overall estimated increase of $13 billion in risk-based capital.

The proposed U.S. calculation shifts to using daily and monthly average data rather than year-end data. Regulators’ stated goal is to reduce opportunities for firms to lower their systemic indicators at year-end, with this change estimated to raise applicable G-SIB scores by nine points on average across firms. Category I banks would need to start capturing data daily and/ or monthly for certain indicators where reporting is currently quarterly. Category IV banks would also be required to start reporting daily values for their total exposure systemic indicator for on-balance sheet items and end-of-month values for off-balance sheet items. These changes are expected to add to operational burdens and would require appropriate systems, processes and controls.

The proposal reduces cliff effects of the G-SIB surcharge by introducing narrower 10 basis point bands for the applicable G-SIB charges versus the current 50. The narrower bands would increase the frequency with which the G-SIB surcharge will change, but the magnitude will be more manageable.

Several foreign banks would be elevated to Category II

Changes in the G-SIB surcharge proposal would result in seven foreign banks and two intermediate holding companies (IHCs) moving to Category II from Category III or IV, creating substantial new liquidity and resolution planning requirements that would be difficult and costly to implement.

Proposed changes affecting all U.S. and foreign FR Y-15 filers would result in a number of institutions becoming subject to Category II requirements based on the Fed’s applicability thresholds. Driving the change are a number of amendments to the FR Y-15 definitions of systemic indicators, with the most significant being the inclusion of derivative exposures, gross of collateral, in cross jurisdictional claims and liabilities. The regulators predict that seven foreign banks would move from Category III or IV to Category II at the combined U.S. operations (CUSO) level and two IHCs would move to Category II, resulting in higher capital and liquidity requirements at the IHC level. U.S. banking organizations with consolidated assets of $100 billion or more, foreign banks with CUSO assets of $100 billion or more and others subject to FR Y-15 should closely evaluate the updated measurement and reporting changes as well as the impact of becoming subject to Category II requirements at the CUSO or IHC level.

Foreign banks moving into Category II at the CUSO level would be subject to daily FR 2052a reporting to the Fed. Implementing reliable, daily FR 2052a reporting has proved to be a major challenge for banking institutions and requires substantial investment in data and reporting systems. IHCs moving to Category II would also be subject to higher liquidity requirements, including daily FR 2052a reporting, 100% coverage requirements for the Liquidity Coverage Ratio (LCR) and the Net Stable Funding Ratio (NSFR). In addition, the two IHCs that would move into Category II would become subject to additional capital requirements, including annual company-run stress testing.

The Fed and FDIC issued resolution planning guidance in 2020 that outlined increased capability requirements for Category II foreign banks. These incremental requirements are materially more onerous than those applicable to Category III and Category IV foreign banks and include capital and liquidity projection requirements, governance playbooks, operational capabilities, legal entity rationalization and derivatives and trading practices. Existing Category II foreign banks have aligned to these expectations over multiple years.

Basel III endgame: Complete regulatory capital overhaul

Operational risk SA could increase RWA by $2 trillion