Treliant Takeaway…U.S. Basel III Capital Reforms

U.S. Basel III Capital Reforms – Headline Takeaways

• Source: federalreserve.gov

Takeaway:

Regulatory agencies are seeking feedback on a proposal to strengthen the banking system by modifying capital requirements for large banks to reflect risks more accurately. This proposal, aligned with Basel III agreement, aims to bolster the system after recent turmoil by applying broader capital requirements to sizable banks (>$100 billion in assets). Proposed changes include standardizing capital aspects, factoring unrealized gains/losses, and implementing transition provisions. If passed, large banks would adopt the new framework beginning July 2025, with full compliance by July 2028.

Treliant plays a pivotal role in assisting banks during this transition. Our expertise lies in navigating regulatory changes and optimizing financial systems. Our services encompass risk assessment, capital framework standardization, and readiness planning, assisting banks in complying with the evolving Basel III requirements. With our guidance, banks can efficiently implement proposed changes, enhance risk measurement practices, and smoothly transition to the new framework, thereby bolstering their strength and resilience in the face of evolving regulations.

Highlights:

1. Dual-stack risk-weighted assets (RWA) capital assessment – Banks are now required to estimate the RWA using the current standardized approach and the new expanded risk-based approach (Collins Amendment) and are ultimately subjected to the higher of the two estimates on their balance sheet. The difference in the two approaches is centered around the denominator side of the capital equation (i.e., credit risk, market risk, operational risk, and CVA risk) for the Category III & IV banks which are now subjected to more granular risk weights on their credit risk measure, including SA-CCR for counterparty credit risk (which is no longer optional). This means, significant operational and computational process burdens on banks.
2. Accumulated other comprehensive income (AOCI) filter requirement expanded to Category III & IV banks – In the past, we’ve noticed that unrealized PnL due to market value changes of available for sale (AFS) [a catch all for debt and equity securities not captured by the “trading” or “held to maturity” portfolio] securities do not typically impact the bank’s net income. However, they do impact the level of equity in the bank’s balance sheet which is tracked through AOCI (i.e., net difference between market and book value of these securities tracked on the balance sheet). This AOCI filter is now applicable for Category III & IV banks in measuring the regulatory capital going forward. In other words, banks no longer have the luxury of AOCI opt-out and therefore need to recognize the unrealized gains and losses on AFS in capital calculations!
3. Counter cyclical buffer (CCyB) – is now applicable for Category IV banks and the stressed capital buffer is now applicable for both the standardized approach and the expanded risk-based approach as well.
4. Significant changes to the regulatory reporting – Banks are now subjected to a series of changes on their regulatory reporting pertaining to credit risk, market risk, operational risk, and capital and systemic risk indicators (i.e., FR Y 14, 15, FFIEC (federal financial institutions examination council) 101/102, 031/041 etc.)
5. Category IV banks are now subjected to supplementary leverage ratio (SLR) – SLR is a new requirement for Category IV banks.
6. Eliminates the use of internal models for credit and operational risk – Credit risk is now subjected to more granular standardized risk weights by replacing the internal models. For operational risk, large banking organizations (LBO) will be required to use an internal loss multiplier based on historical operational losses to a business indicator component. The ILM must be no less than 1. Therefore, operational risk capital requirements will increase as operational risk losses increase. Comparatively, the EU and the UK have set the ILM to 1, with no fluctuation due to historical losses, and Canada does not apply a floor or cap.
7. Gold plating credit risk weights – Residential real estate risk weights and non-real estate risk weights are 20% and 10% higher respectively than international standards. Furthermore, lower risk weights are not included for corporate small and medium enterprises and other short-term bank exposures!
8. Market risk – Requires banks to obtain prior written approval from the Supervisor before going live with internal models at individual trading desk level. Additionally, the market risk internal models are subjected to “output floor” to limit the capital deductions from the use of internal models.
9. Applicability of various risk based and non-risk-based measures for Category I-IV banks – The proposed rules change the applicability of the capital standards based on the regulators’ view of the size and complexity of the institution. Further details are provided in the table below.

What Does This Mean for Financial Institutions?

We expect significant capital increase for G-SIBs and intermediate holding companies (IHC) at all levels including market risk, credit risk, and operational risk. The Fed estimates 16% increase to CET1 and 20% increase to RWA for the U.S. G-SIBs and IHCs.

Whilst the Basel III endgame NPR is under the spotlight, we’re afraid the Fed’s standalone GSIB / FR Y-15 NPR warrants further analysis and more meaningful discussions as the seven FBOs (with combined assets of U.S. $100B or more is likely to witness an increase in their reported value of their cross jurisdictional activity above $75B!) are going to be subjected to Category II standards which include daily liquidity reporting (as opposed to the monthly or no liquidity reporting), monthly (instead of quarterly) internal liquidity stress testing, and full (instead of reduced) liquidity risk management. On one end, these changes will benefit the banks as they get to strengthen their liquidity risk management alongside enhancing their liquidity positions, and on the other end, the FBOs U.S. operations will bear the brunt of higher operational expenses!

In the next few months, we expect banks to revisit their trading and banking book portfolios and make significant adjustments to their business models in order to deal with the punitive capital, RWA, and cumbersome operational changes!

It is worth noting that if the agencies adopt the NPR, 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.

With the U.S. intending to go live starting July 1, 2025 (6 months later than international jurisdictions), we might see pressure from the industry to defer the go-live dates by six months to avoid regulatory arbitrage and achieve harmonization of the global implementation deadlines.

Additional Sources:

https://www.federalreserve.gov/aboutthefed/boardmeetings/gsib-memo-20230727.pdf

https://www.federalreserve.gov/aboutthefed/boardmeetings/fact-sheet-basel-20230727.pdf

https://www.federalreserve.gov/aboutthefed/boardmeetings/basel-iii-reforms-overview-20230727.pdf

https://www.federalreserve.gov/aboutthefed/boardmeetings/frn-basel-iii-20230727.pdf

https://www.federalreserve.gov/aboutthefed/boardmeetings/frn-gsib-20230727.pdf