United States: The Federal Reserve, OCC, And FDIC Propose "Basel III Endgame" Capital Rules

On July 27, 2023, the Board of Governors of the Federal Reserve System (the Federal Reserve), the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) (together, the Agencies) published the long-awaited notice of proposed rulemaking (NPR) to implement the final components of the Basel III standards (Basel III Endgame) set by the Basel Committee on Banking Supervision in 2017.¹ The NPR, which spans over a thousand pages, would substantially revise the capital requirements applicable to banking organizations (which is defined to include traditional savings and loan holding companies and U.S. intermediate holding companies of foreign banking organizations) with US$100 billion or more in total consolidated assets and their depository institutions (referred to as "large banking organizations"), as well as firms with significant trading activities. Specifically, the Agencies expect the NPR would (i) improve the calculation of risk-based capital requirements to better reflect the risks, (ii) reduce the complexity of the framework, (iii) enhance the consistency of requirements among banking organizations of similar asset size, and (iv) facilitate "more effective supervisory and market" assessments of capital adequacy.

Overview

For affected banking organizations, the NPR represents substantial change, both in terms of methodology and levels. Consistent with the Basel III Endgame agreement,² the proposal represents a turn away from a reliance on the internal models approach to capital first embraced as part of the Basel II reforms. Large banking organizations would instead be required to compute their capital using expanded standardized approaches to credit and operational risk, together with a revised approach for market risk. Notably, the NPR would scope "Category III and IV" banking organizations (generally, those with between US$100 and US$700 billion in assets) into much of the revised capital framework, imposing substantial regulatory adjustment costs on those organizations.

In terms of levels, the proposed changes are estimated by the Agencies to result in an aggregate 16% increase in common equity tier 1 capital requirements for affected bank holding companies, with the largest increases affecting the largest and most complex banks, and especially those with large trading businesses. The NPR would take effect starting in 2025, with a gradual phase-in over three years intended to give banks sufficient time to adapt to the changes while minimizing any potential adverse impact. Despite the gradual phase-in, the Agencies estimate that "[m]ost banks currently would have enough capital to meet the proposed requirements."³

It is notable that the NPR was released with a level of dissension uncommon in interagency regulations. The vote at the FDIC board was 3-2 for publication of the proposed rule, and the vote at the Federal Reserve Board was 4-2, with strong dissents from some board members.⁴ Even some of the Federal Reserve Board members who voted for publication, including Federal Reserve Chair Jerome Powell, indicated that they would need to consider comments from the public before finalizing the rule on capital requirements.⁵ This suggests that it is important for industry participants and other interested parties to submit comments on the proposed rule. Comments must be received by the Agencies by November 30, 2023.

What institutions would be covered by the NPR?

The NPR would affect, to varying degrees, large banking organizations (with total assets of US$100 billion or more and their subsidiary depository institutions), and banking organizations with significant trading activities.

The NPR would impose the strictest capital requirements on global systemically important banking organizations (GSIBs, Category I) and banking organizations with greater than US$700 billion in assets (Category II) but would also impose expanded capital requirements on banking organizations with assets between US$100 billion and US$700 billion (Categories III and IV). Although the inclusion of all Category III and IV firms was not required under the Basel III Endgame standards, the NPR states that doing so was justified, in part, by recent bank failures that demonstrate the impact firms in that asset class can have on financial stability.

For banking organizations with less than US$100 billion in total assets, only the market risk provisions of the NPR would apply, and only in cases where a banking organization engages in significant trading activity, defined as having US$5 billion or more in trading assets. Capital requirements for community banks are unlikely to be directly affected by the NPR.⁶

What are the most significant changes included under the NPR?

The NPR includes many significant revisions related to capital requirements, including:

• All banking organizations with assets greater than US$100 billion would be required to adhere to a revised framework for calculating risk-weighted assets, effectively increasing capital requirements. The largest increase to capital requirements is expected to be experienced by GSIBs (Category I) and banking organizations with greater than US$700 billion in assets (Category II).
• Banking organizations would no longer be permitted to use internal models for many aspects of risk-weighted asset calculations. To determine credit risk capital requirements, firms would be required to use the newly expanded risk-based approach, which provides more risk sensitivity, in addition to the existing standardized approach. For operational risk capital requirements, firms would be required to use a standardized approach rather than internal models. For market risk, firms would be required to use a standardized approach unless internal models to measure market risk were approved by the appropriate Agency.
• Banking organizations with assets between US$100 billion and US$700 billion (Categories III and IV) would be required to include accumulated other comprehensive income (AOCI), capital deductions, and rules for minority interest in their common equity tier 1 calculations. Larger banking organizations are already subject to these requirements.⁷
• Banking organizations with assets between US$100 billion and US$250 billion (Category IV) would become subject to the supplementary leverage ratio and countercyclical capital buffer. Larger banking organizations are already subject to these requirements.

What's not in the NPR?

The NPR does not include changes that would affect the main drivers of the three large bank failures in March and May 2023. Although the NPR would impose detailed requirements and enhanced capital requirements related to a range of standard risk factors, including interest rate risk, the focus for interest rate risk is on securities held for sale, as well as derivatives, securities, and financial instruments for which trading markets exist, and (other than qualitative disclosures) less so on the interest rate risk on a banking organization's portfolio loans and long-term instrument holdings that are not held for sale or treated as trading assets. Nor does the NPR directly address funding risk for large deposits. Other guidance issued by the Agencies on July 28, 2023⁸ updates prior guidance on funding risk, but does not address the flaws in the existing net stable funding ratio and liquidity coverage ratio liquidity rules in their treatment of large operating accounts and accounting for high-quality liquid assets that are not marked to market.

The NPR also does not propose changes to total loss absorbing capacity (TLAC) or long-term debt (LTD) requirements, which Michael Barr, Vice Chair of Supervision of the Federal Reserve, has stated should apply to banking organizations with US$100 billion or more in assets.⁹ See our Advisory here on the advanced notice of rulemaking released by the Federal Reserve and FDIC in October 2022, requesting comments on proposed TLAC and LTD requirements for Category II and Category III organizations.

When would the proposed changes take effect?

If adopted as proposed, the expanded total risk-weighted asset requirements and (for banking organizations subject to Category III or IV capital standards) the AOCI regulatory capital adjustments would be phased in starting July 1, 2025 until June 30, 2028.

What should banks do now?

The NPR, if adopted as proposed, would significantly increase capital requirements for many large banks. Banking organizations should begin to prepare for increased capital requirements and submit any comments they may have regarding the NPR to the OCC, the Federal Reserve, and the FDIC. Given the relatively few institutions impacted by the NPR, we recommend that each affected institution submit its own comment letter. We regularly assist clients with comments on proposed rules such as these and are available to consult on drafting comments that would be valuable contributions to the Agencies in finalizing the NPR. Comments must be received by the Agencies by November 30, 2023.

Footnotes

1. OCC, Federal Reserve, FDIC, Regulatory Capital Rule: Amendments Applicable to Large Banking Organizations and to Banking Organizations with Significant Trading Activity (July 27, 2023) (the NPR), available here.

2. See Basel Committee on Banking Supervision, Basel III: Finalising Post-Crisis Reforms (Dec. 2017), available here.

3 .Federal Reserve, FDIC, and OCC, Joint Press Release (July 23, 2023), available here.

4. See, e.g., Statement by Governor Christopher J. Waller (July 23, 2023), available here.

5. See Statement by Chair Jerome H. Powell (July 27, 2023), available here.

6. However, "[] smaller banking organization could be subject to the newly revised market risk capital rule if its trading assets and trading liabilities are at least US$5 billion or at least 10 percent of its total assets." OCC, Federal Reserve, FDIC, "Interagency Overview of the Notice of Proposed Rulemaking for Amendments to the Regulatory Capital Rule" (July 27, 2023), available here.

7. In recognition that AOCI at banking organizations is primarily driven by market value fluctuations to their investment securities portfolios held for sale, the agencies included a question for public comment as to whether any changes should be considered with respect to fair value fluctuations to held to maturity portfolios which are disclosed in financial statement footnotes but not recognized on the face of the balance sheet. See Question 10, NPR at 34. Community banks should pay close attention to the AOCI changes to the capital calculations for the larger institutions as the investment banking and analyst community already performs similar calculations in their published reports on institutions of all sizes.

8. Federal Reserve, FDIC, National Credit Union Administration, OCC, "Agencies Update Guidance on Liquidity Risks and Contingency Planning" (July 28, 2023), available here.

9. Michael S. Barr, "Holistic Capital Review," Speech at the Bipartisan Policy Center (July 10, 2023), available here.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.