Completing the banking puzzle | World Finance

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For fans of American football used to watching advertisements about fast food chains, the last few months have been a crash course in banking regulation, with commercial breaks during NFL games often featuring ads that warn them about sudden hikes in their mortgage rates. And that is just the least aggressive part of a campaign the US banking industry has launched against a reform in capital rules, announced by regulators last summer. “I doubt that people seeing those ads have any idea what they are talking about,” said Michael Ohlrogge, an expert on financial regulation teaching at NYU School of Law, adding: “They might perhaps activate people who have a knee-jerk reaction that all regulation is bad.”

Higher, stricter, harsher
The reform is the latest attempt to buttress the country’s financial system, proposed by the Federal Reserve, the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation. It has been named ‘Basel III endgame’ after the Swiss city where the Bank for International Settlements (BIS) that oversees central banks is based. Banks with over $100bn in assets will be obliged to set aside tens of billions more by early 2028. They will also have to include a larger part of losses in capital ratios and will no longer be able to use lower historical capital losses to reduce their capital requirements. US regulators have expressed hope that the reform will reduce systemic risk and improve the US banking sector’s resilience.

The Fed has indicated its willingness to compromise and water down the most stringent rules

The overhaul aims to harmonise US capital rules with international standards. Most developed economies have already implemented capital rules dictated by the Basel Committee on Banking Supervision, which sets global capital requirements. In 2017, the committee reached an agreement for higher capital requirements to address concerns that ‘Basel III,’ a banking regulation package implemented after the credit crunch, had failed to tackle systemic risks. However, the committee’s rules are non-binding and subject to adjustment to national regulatory priorities.

In response, US regulators chose to apply stringent standards, particularly in operational risk, which includes novel threats such as cyber crime. One reason is the recent turmoil in the country’s banking system, echoing the darker days of the financial crisis. Three of the largest bank failures in US history took place during the last three years, putting the recovery from the Covid slump and the effectiveness of post-2009 banking regulation into question. The 2023 collapse of Silicon Valley Bank, which albeit small by US standards, held a crucial role in the tech ecosystem, raised eyebrows about the practices of smaller banks. Just a few months later, First Republic, a San Francisco-based bank, followed suit. Crucially, the proposed rules also cover regional lenders previously exempt from strict capital requirements.

Banks may also have to increase their capital when regulators expect a recession. What regulators are keen to avert are more bank bail-outs, an issue that caused public resentment in the aftermath of the Great Recession. “Since the real estate market and debt scenarios have started to mimic the pre-2008 crash scenarios, regulatory organisations are trying to prevent a banking sector collapse with strict policies,” said Ethan Keller, president of Dominion, a US-based network of legal and financial advisors.

Fierce pushback
When announced last summer, the proposals sent a shockwave across Wall Street. An analysis by the law firm Latham & Watkins found that a staggering 97 percent of responding institutions to the public consultation process found the changes problematic. Banks fear that stricter capital requirements will limit their lending capabilities, hurting the US economy and especially SMEs. The bone of contention is risk-weighted assets (RWA), which are measured based on a risk weighting assigned to banks’ operations. As the denominator to determine capital ratios against future losses, low RWAs help banks look stronger financially. Previously, banks were allowed to use their own models to gauge risk, but discrepancies in modelling across the industry have urged regulators to set a common standard to measure operational risk. Critics argue that this will increase capital requirements for mortgages and corporate loans, and even put products such as the hedging contracts airlines use for fuel purchases in jeopardy.

“The pushback is justified, because the rules will have costs but no clear benefit,” said Charles Calomiris, an expert on financial institutions teaching at the University of Austin. Other experts, however, question the validity of the banks’ claims. “If the loans are good loans to make in the first place, why wouldn’t they be willing to fund them with a portion of money from their shareholders,” NYU’s Ohlrogge said, adding: “The kind of loans that capital requirements are going to lead to a reduction in are loans that were bad loans to start with – that is, loans that only make sense to the bank if it can get the profits if the loans perform well, but pass off the costs if they perform badly.” A 2016 BIS study found that increased equity capital is linked to more lending. Critics of banks also argue that their real concern is pay, as higher equity capital will hit executive bonuses based on return-on-equity, and possibly dividends and share buybacks.

Regulators estimate that the new rules will lead to an aggregate 16 percent increase in capital requirements for the largest banks. However, they clarified in their initial proposal that “the largest US bank holding companies annually earned an average of 180 basis points of capital ratio between 2015–2022,” meaning that the hit would be mild at best. The 12 largest US banks sit on a record $180bn of excess common equity tier one capital, a common measure of their financial strength. Several banks and lobbying groups have pushed back against these projections. The Bank Policy Institute, which represents large and mid-sized banks, estimates that the largest ones will have to increase their capital up to 24 percent. Some banks have also argued that they are already financially strong, expressing concerns that higher capital requirements would only lead to higher costs, rather than more safety. The Financial Services Forum (FSF), a group representing the eight largest US banks, estimates that its members had $940bn of capital in 2023, three times more than in 2009.

Three of the largest bank failures in US history took place during the last three years

Another concern is potential loss of international competitiveness. US banks will have to comply with more stringent capital requirements than those their competitors face, currently standing at 3.2 percent for large UK banks and 9.9 percent for EU-based ones. Diminished internal competition could be another unintended consequence if more banks merge to comply with the new rules. One of the regulators, the Federal Deposit Insurance Corporation, has recently proposed reforms that would make big bank mergers more difficult. “Not only do higher capital requirements make US banks less competitive relative to foreign banks, higher capital requirements also make regional and larger US banks less competitive relative to community banks,” said Matthew Bisanz, partner in the financial services, regulatory and enforcement practice of the US law firm Mayer Brown. “Considering EU banks’ existing technology and framework to maintain the Basel framework, this will give them a competitive advantage over US banks,” said Dominion’s Keller, adding: “As this framework means additional costs for training, tracking, and setting aside a specific portion of the capital, the banks will churn out the additional costs from the customers. Hence, smaller banks with Basel Endgame exception will gain a new clientele not willing to pay extra money for US banking conglomerates.”

For its part, the Fed has indicated its willingness to compromise and water down the most stringent rules of the initial proposal, with a final plan expected to be announced this summer. Its chair, Jay Powell, has said that “broad and material changes” are likely and has acknowledged that a balance has to be struck between potential costs and the stability of the financial system. Other Fed board members are even more sceptical. Two of them, Michelle Bowman and Christopher Waller, have raised concerns over reduced competition, curtailed lending, less liquidity and costlier credit as a result of the changes.

Basel rules under fire
The reform has entered the political fray amid the campaign for the forthcoming presidential election. The banking industry has launched a website where voters can notify elected representatives about their concerns. Banks are also lobbying lawmakers to put pressure on regulators. Many republican congressmen and senators have openly opposed the reforms, and a future Trump administration is expected to pressurise regulators to water down the proposals. When the initial proposals were announced last summer, regulators were concerned about recent bank failures, while Biden administration officials were worried about an imminent financial crisis. The reform “reflects the greater political pressure on US regulators and politicisation of US regulation post-Dodd-Frank,” Bisanz said, referring to a post-2009 piece of legislation that reined in the worst excesses of the financial services sector, adding: “The campaign of banks reflects the seriousness of the increase in the capital requirements, as well as the weakened position that US regulators are in after missing the bank failures last year. There also is an element that courts are questioning decisions by regulators.”

More ominously, the overhaul and the resulting outcry have provided ammunition to the many critics of Basel rules. “Basel is so weak that even in the US, where large banks succeed in avoiding strict prudential guidelines, it has historically been so inadequate that the US adopted stricter but still ineffective standards,” said Calomiris. Stricter capital requirements elsewhere and even another overhaul of Basel regulations may be on the cards, as banks and regulators worldwide take notice of changes in US regulation. Ironically, the government of Switzerland, where BIS is based, has put forward proposals to increase capital requirements for Swiss banks after the collapse of Credit Suisse in March 2023. “The more rigorous of capital regulations the US adopts, the more encouragement it provides for other countries to adopt rigorous rules,” said Ohlrogge.