Federal Banking Agencies Propose Basel III Endgame Capital Rules

On July 27, 2023, the Federal Reserve, FDIC, and OCC issued a notice of proposed rulemaking and request for comment on a proposal (the Proposal) to implement the final components of the Basel III Capital Accords, often referred to as the Basel III endgame — and to strengthen the banking system following the failure of Silicon Valley Bank (SVB) — by applying a broader set of capital requirements to banking organizations with $100 billion or more in assets. The Proposal would not generally affect capital requirements for banks with less than $100 billion in assets.

The Proposal was issued in tandem with the Federal Reserve’s July 27, 2023, notice of proposed rulemaking and request for comment on a proposal to adjust the calculation of the so-called GSIB surcharge applicable to the largest and most complex banks.

Calculation of Capital Ratios and Application of Buffer Requirements

• Under the Proposal, large banking organizations (LBOs; i.e., banking organizations with total assets of $100 billion or more and their depository institution subsidiaries) would be required to calculate total risk-weighted assets under both a new expanded risk-based approach (ERBA) — which would generally replace the current use of internal models — and a standardized approach.
• Under the ERBA, LBOs would calculate total risk-weighted assets using new standardized approaches for credit risk and operational risk and revised approaches for market risk and credit valuation adjustment risk.
• LBOs would be required to calculate their risk-based capital ratios (i.e., common equity Tier 1 capital (CET1) ratio, Tier 1 capital ratio, and total capital ratio) using total risk-weighted assets calculated under each of the two approaches and use the lower of each ratio calculated as the binding ratio for regulatory purposes. As a result of the Proposal, LBOs continue to be subject to a dual-requirement structure intended to ensure that the capital requirements applicable to LBOs are at least as strict as those applicable to smaller banking organizations.
• LBOs would be permitted to use internal models for market risk, but such models would be subject to enhanced requirements for supervisory review.
• The Proposal would introduce an “output floor” to the calculation of expanded total risk-weighted assets, which would serve as a lower bound on the risk-weighted assets under the ERBA.
• The Proposal would extend the application of the supplementary leverage ratio and the countercyclical capital buffer requirements (if activated) to all LBOs, with Category I firms remaining subject to the strictest standards.
  
  • The 2019 rules tailored regulations for domestic and foreign banks to align with their risk profiles by introducing a framework that separates LBOs into four different categories based on risk factors, with the largest and most complex firms included in Category I, and size and complexity decreasing across Categories II through IV.
• The Proposal would amend the capital plan rule, stress testing rule, and buffer framework to incorporate capital ratios calculated and projected under the ERBA.
• The Proposal would not change the minimum required risk-based capital ratios; however, as a result of changes in the definition of capital (which affects the numerator of the capital ratio) and revisions in risk weighting (which affects the denominator of the capital ratio), affected banking organizations may need to raise capital, shift the composition of their balance sheet toward lower risk-weight assets, or employ some combination of these approaches to maintain the same capital ratios that would be computed under current rules.

Definition of Capital

• Category III and Category IV organizations — generally, those LBOs with total consolidated assets of at least $100 billion but less than $700 billion — are currently permitted to make a one-time election to opt out of recognizing most elements of accumulated other comprehensive income (AOCI) within regulatory capital. This election, commonly known as the AOCI filter, has the effect of insulating regulatory capital from changes in the value of the available-for-sale (AFS) securities portfolio. The Federal Reserve’s April 28, 2023, review of the SVB failure specifically noted that SVB was permitted to avail itself of the AOCI filter, which would not have been possible prior to the adoption of the 2019 tailoring rule. Subject to a three-year transition period, the Proposal would require Category III and Category IV LBOs to include most components of AOCI in CET1, which would require all net unrealized holding gains and losses on AFS securities resulting from changes in fair value to be reflected in CET1, including those that result from changes in interest rates.
• The Proposal would require Category III and Category IV organizations to apply the capital deductions and minority interest treatments that are currently applicable to larger organizations subject to Category I or Category II capital standards. Currently, Category I and Category II organizations (e.g., global systemically important banks (GSIBs) and banking organizations with at least $700 billion in assets or at least $75 billion of cross-jurisdictional activity) are required to deduct from CET1 the amounts of mortgage servicing assets (MSAs), temporary difference deferred tax assets (DTAs) that the LBO could not realize through net operating loss carrybacks, and significant investments in the capital of unconsolidated financial institutions in the form of common stock that individually exceed 10% of CET1. Category I and Category II organizations must also deduct from CET1 the aggregate amount of these items not deducted under the 10% threshold deduction but that nevertheless exceeds 15% of CET1. In addition, these organizations must deduct any amount of nonsignificant investments in the capital of unconsolidated financial institutions, including certain covered debt instruments issued by US and foreign global systemically important organizations, in excess of 10% of CET1, and the entire amount of significant investments in the capital of unconsolidated financial institutions not in the form of common stock. However, current rules require the Category III and Category IV LBOs to deduct from CET1 the amounts of MSAs, temporary difference DTAs that the LBO could not realize through net operating loss carrybacks, and investments in the capital of unconsolidated financial institutions that individually exceed 25% of CET1.
• The Proposal would impose limits on the amount of minority interest in a consolidated subsidiary that a Category III or Category IV organization may include in capital based on the amount of capital held by the consolidated subsidiary relative to the amount of capital the subsidiary would have been required to maintain to avoid any restrictions on capital distributions and discretionary bonus payments under the capital conservation buffer requirements. 
• Category III and Category IV organizations would be subject to certain disclosure requirements with respect to capital instruments that would require the governing agreement, offering circular, or prospectus of an additional Tier 1 or Tier 2 capital instrument to disclose that holders of the instrument may be fully subordinated to interests held by the US government in the event that the institution fails.

Credit Risk

• The ERBA is intended to provide for more transparent capital requirements for credit risk exposures across LBOs than is currently found in the internal models-based approaches of the advanced approaches rule, and to facilitate easier comparisons across LBOs and reduce variability in risk-weighted assets for similar exposures.
• The ERBA for credit risk is also intended to be more risk-sensitive than the approach currently used in the US and, therefore, purports to better account for risks faced by LBOs, reduce management discretion, and more strongly align an LBO’s risk with the incentives for prudent risk management.
• The Proposal would amend risk weighting relative to the current standardized approach for equity exposures to government-sponsored enterprises (GSEs) and exposures to subordinated instruments issued by GSEs; exposures to depository institutions, foreign banks, and credit unions; exposures to subordinated debt instruments; real estate exposures; retail exposures; corporate exposures; defaulted exposures; and some off-balance sheet exposures, such as commitments.
• The ERBA has been designed to incorporate “credit drivers” (i.e., characteristics of transactions that are linked to different credit risk profiles). As an example, for exposures to depository institutions, the Proposal would provide three categories for bank exposures ranked from the highest to the lowest in terms of creditworthiness, taking into account whether the obligor is considered “investment grade” or “speculative grade” and incorporating the obligor’s publicly disclosed capital levels to differentiate the financial strength of the obligor in a way that is intended to be objective and transparent to regulators and the public.
• The Proposal would introduce an enhanced definition of a defaulted exposure that is intended to capture the elevated credit risk of exposures where the LBO’s reasonable expectation of repayment has been reduced, including exposures where the obligor is in default on an unrelated obligation.
• The Proposal would also introduce updated credit conversion factors that LBOs would apply to the notional amount of an off-balance-sheet item to calculate the exposure amount for such an item, reflecting the expected proportion of the item that would become an on-balance-sheet credit exposure. For commitments, for example, the Proposal would modify the credit conversion factors and simplify the treatment relative to the standard approach by no longer differentiating based on maturity of the facility. 
• LBOs are permitted to recognize certain types of credit risk mitigants (e.g., guaranties, credit derivatives, and collateral) under the risk-based capital rules, so long as the credit risk mitigants satisfy certain standards under the rule. As with the current rule, the Proposal acknowledges the ability of such measures to reduce the credit risk of an exposure and, thereby, the risk-based capital requirement. As the Proposal would eliminate the use of internal models for credit risk, the Proposal would replace certain methods for recognizing credit-risk mitigants — the internal models methodology, the simple VaR approach, the PD substitution approach, the LGD adjustment approach, and the double default treatment — with standardized approaches.
• As LBOs are expected to maintain capital commensurate with the level of risk and have an adequate understanding of the impact of their lending on the organization’s credit risk, an LBO’s due diligence on its credit portfolio is critical for the LBO to assess its risk exposure and identify and implement appropriate mitigating measures. In light of the significance of appropriate due diligence, the agencies have asked if due diligence requirements should be incorporated in the final rule and if there are advantages or disadvantages in calibrating risk weights based on whether such due diligence requirements have been met.

Securitization Framework

Under the Proposal, the existing securitization framework generally would be modified as follows:

• The Proposal would provide additional operational requirements for synthetic securitizations and a modified treatment for resecuritizations that meet the operational requirements, including (a) eliminating the option for LBOs to treat resecuritization exposures that meet the operational requirements as if they had not been resecuritized; (b) expanding the applicability of the operational requirements for early amortization provisions to synthetic securitizations; (c) prohibiting an originating LBO from recognizing the risk-mitigating benefits of a synthetic securitization that includes synthetic excess spread; and (d) requiring any applicable minimum payment threshold (i.e., a contractual minimum amount that must be delinquent before a credit event is deemed to have occurred) for the credit risk mitigant to be consistent with standard market practice.
• The Proposal would replace the supervisory formula approach and standardized supervisory formula approach (SSFA) with a new securitization standardized approach (SEC-SA). Relative to the SSFA, the SEC-SA modifies the definitions of attachment point and detachment point, W parameter, and KG; provides a higher p-factor; sets a lower risk-weight floor of 15% for securitization exposures that are not resecuritization exposures; and sets a higher risk-weight floor of 100% for resecuritization exposures. If the LBO cannot, or chooses not to, apply the SEC-SA, the LBO would be required to apply a 1,250% risk weight to the exposure, which is equivalent to a requirement to hold dollar-for-dollar capital against such exposures.
• The Proposal would not permit LBOs to recognize any risk-mitigating benefit for nth-to-default credit derivatives in which the LBO is the protection purchaser under either the proposed credit risk mitigation framework or the proposed securitization framework.
• The Proposal would require an LBO that acts as a counterparty to interest rate and foreign exchange derivatives that do not provide credit enhancement to set the risk weight on such derivatives equal to the risk weight calculated under the SEC-SA for a securitization exposure that is pari passu to the derivative contract or, if such an exposure does not exist, the risk weight of the next subordinated tranche of the securitization exposure.
• The Proposal would modify the treatment for overlapping exposures by allowing an LBO to (a) treat two non-overlapping securitization exposures as overlapping to the degree that the LBO assumes that obligations with respect to one of the exposures covers obligations with respect to the other exposure; and (b) recognize an overlap between relevant risk-based requirements for securitization exposures and market risk covered positions, provided the LBO is able to calculate and compare the capital requirements for the relevant exposures.
• The Proposal would provide new maximum capital requirements and eligibility criteria for certain senior securitization exposures, allowing an LBO to cap the risk weight applied to a senior securitization exposure that is not a resecuritization exposure at the weighted-average risk weight of the underlying exposures (the look-through approach), provided that the LBO has knowledge of the composition of all of the underlying exposures. Despite the cap, the Proposal would require LBOs to set a floor for the total risk-based capital requirement under the look-through approach at 15%.
• The Proposal would require an LBO to deduct from CET1 any portion of a credit-enhancing interest-only strip that does not constitute an after-tax-gain-on sale, regardless of whether the securitization exposure meets the proposed operational requirements.
• The Proposal would establish a new framework for non-performing loan (NPL) securitizations, requiring an LBO to assign a 100% risk weight to a securitization exposure to an NPL securitization if certain requirements are met. If the NPL securitization exposure is not a senior securitization exposure or the purchase price discount is less than 50%, the LBO would be required to use the SEC-SA to calculate the risk weight. If the exposure does not meet the requirements of the SEC-SA, the LBO must assign a risk weight of 1,250% to the exposure.

Equity Exposures

• The Proposal would eliminate the internal models approach for determining the risk-weighted asset amount for certain equity exposures. The current capital rule’s advanced approaches equity framework permits use of an internal models approach for publicly traded and non-publicly traded equity exposures and equity derivative contracts. Under the Proposal, material publicly traded equity exposures would generally be subject to a proposed market risk framework. Similarly, equity exposures to investment funds for which the LBO has access to the investment fund’s prospectus, partnership agreement, or similar contract that defines the fund’s permissible investments and investment limits would be subject to a market risk framework if the LBO is able to either (a) calculate a market risk capital requirement for its proportional ownership share of each exposure held by the investment fund; or (b) obtain daily price quotes. The Proposal would subject illiquid or infrequently traded equity exposures to a standardized approach similar to the standardized approach in the current rule.

Operational Risk

• The Proposal would introduce a capital requirement for operational risk based on a standardized approach, replacing the internal models used by Category I and Category II firms today under the advanced measurements approaches (AMA).
• The Proposal identifies challenges to LBOs, market participants, and the supervisory process resulting from the use of internal models, noting that AMA exposure estimates can present substantial uncertainty and volatility, which introduces challenges to capital planning processes and results in a lack of transparency and comparability across LBOs, making it challenging for supervisors and market participants alike to assess relative magnitude of operational risk across LBOs, the adequacy of operational risk capital, and the effectiveness of operational risk management practices.
• The operational risk capital requirements under the new standardized approach would be a function of an LBO’s business indicator component and its internal loss multiplier.
  
  • The business indicator component would provide a measure of the operational risk exposure of the LBO calculated based on its business indicator, which would serve as a proxy for the LBO’s business volume based on inputs from its financial statements. The business indicator would then be multiplied by scaling factors that increase with the business indicator. 
  • The internal loss multiplier — which must be no less than 1 — would be based on the ratio of an LBO’s historical operational losses to its business indicator component and would increase the operational risk capital requirement as historical operational losses increase.
  • An LBO’s operational risk capital requirement would be equal to its business indicator component multiplied by its internal loss multiplier. Similar to the current capital rule, risk-weighted assets for operational risk would be equal to 12.5 times the operational risk capital requirement.

Disclosure Requirements

Under the Proposal, enhanced disclosure requirements would apply to all LBOs, including those in Category III or IV. The Proposal would revise existing qualitative disclosure requirements and introduce new ones, and it would remove from the disclosure tables most of the quantitative disclosures, which are instead expected under separate rulemakings to be included in regulatory reporting forms. The Proposal would retain the requirement that an LBO disclose its risk management objectives, revise the risk areas to which disclosure requirements apply, and require descriptions of risk management objectives as they relate to the LBO overall. Changes include:

• Table 5, “Credit Risk: General Disclosures”: The Proposal would require disclosure of additional information regarding an LBO’s risk management policies and objectives for credit risk, including disclosures of (a) how an LBO’s business model translates into the components of its credit risk profile and how it defines credit risk management policy and sets credit limits; (b) the organizational structure of its credit risk management and control function, as well as interactions with other functions; and (c) information on its policies related to reporting of credit risk exposure and the credit risk management function that are provided to the LBO’s leadership.
• Table 6, “General Disclosure for Counterparty Credit Risk-Related Exposures”: The Proposal would require disclosure of an LBO’s (a) methodology for assigning economic capital for counterparty credit risk exposures, as well as its policies regarding wrong-way risk exposures; (b) risk management objectives and policies related to counterparty credit risk; (c) policies relating to guaranties and other risk mitigants and assessments concerning counterparty credit risk; and (d) the increase in the amount of collateral that it would be required to provide in the event of a credit rating downgrade.
• Table 7, “Credit Risk Mitigation”: The Proposal would require a breakdown of an LBO’s credit derivative providers (including by rating class or by type of counterparty).
• Table 8, “Securitization”: The Proposal would require disclosure of whether the LBO provides implicit support to a securitization and the risk-based capital impact of such support.
• Table 11, “Additional Disclosure Related to the Credit Quality of Assets”: The Proposal would establish a new table that requires (a) information on the scope of “past due” exposures;,(b) the scope of exposures that qualify as “defaulted exposures” or “defaulted real estate exposures”; and (c) the scope of exposures that qualify as a “loan modification to borrowers experiencing financial difficulty.”
• Table 12, “General Qualitative Disclosure Requirements Related to CVA”: The Proposal would establish a new table that requires disclosure of information pertaining to credit valuation adjustment (CVA) risk, including an LBO’s risk management objectives and policies for CVA risk and information related to its CVA risk management framework (e.g., processes implemented to identify, measure, monitor, and control CVA risks and effectiveness of CVA hedges).
• Table 13, “Qualitative Disclosures for Banks Using the SA-CVA”: The Proposal would establish a new table that requires an LBO approved to use the standardized CVA approach (SA-CVA) to disclose the LBO’s risk management framework, including description of (a) the LBO’s framework; (b) how senior management is involved in the framework; and (c) the governance of framework (e.g., documentation, independent risk control unit, independent review, and independence of data acquisition from lines of business).
• Table 14, “General Qualitative Information on a Banking Organization’s Operational Risk Framework”: The Proposal would establish a new table that requires disclosure of information regarding an LBO’s operational risk management processes, including (a) policies, frameworks, and guidelines for operational risk management; (b) the structure and organization of its operational risk management and control function; (c) its operational risk measurement system; (d) the scope and context of its reporting framework on operational risk to executive management and to the board of directors; and (e) the risk mitigation and risk transfer used in the management of operational risk.
• Table 15, “Main Features of Regulatory Capital Instruments and of Other TLAC-Eligible Instruments”: The Proposal would establish a new table that requires (a) disclosure of information regarding the terms and features of an LBO’s regulatory capital instruments and other instruments eligible for the Federal Reserve’s total loss absorbing capacity (TLAC) rule; (b) description of the main features of its regulatory capital instruments; and (c) disclosure of the full terms and conditions of all instruments included in regulatory capital. GSIBs are also required to describe the main features of their covered debt positions and their full terms and conditions.

Market Risk

• The Proposal would revise the current market risk framework, which allows banking organizations with significant trading positions that are subject to market risk capital requirements to use internal models at the banking organization level. Instead, the proposal would introduce the concept of a trading desk and permit use of internal models only at the trading desk level and only with respect to those trading desks that can appropriately capture the risk of market risk covered positions in the organization’s internal models. Other trading desks not permitted to use internal models would instead be required to use a proposed standardized measure.

Credit Valuation Adjustment Risk

• The Proposal would require Category I, II, III and IV LBOs to reflect in risk-weighted assets the potential losses on OTC derivative contracts resulting from increases of CVA for all OTC derivative contract counterparties, subject to certain exceptions.
• The value of an OTC derivative contract, and the LBO’s exposure to its counterparty, changes over the life of the contract based on movements in the value of the reference rates, assets, commodity prices, or indices underlying the derivative contract. In addition to exposure to changes in the market value of the OTC derivative contract itself, the LBO is also exposed to risk that its counterparty will fail to meet its obligations under the agreement. The amount of the loss suffered by the LBO because of a counterparty default can vary whether the market value of the derivative agreement is positive or negative and can fluctuate over time as market conditions change.
• The valuation change of an OTC derivative contract resulting from the risk that the counterparty defaults prior to the expiration of the contracts is known as CVA and depends on counterparty credit spreads, which reflect the creditworthiness of the counterparty perceived by the market, and credit exposure generated by CVA risk covered positions that the market would expect at various future points in time.
  
  • CVA risk has two components: a counterparty credit spread component, with CVA increasing with the deterioration in the perceived creditworthiness of a counterparty, and an exposure component, with CVA increasing with increases in the expected future exposure.
• The Proposal would provide two measures for calculating CVA risk capital, a basic measure for CVA risk, which recognizes only the credit spread component of CVA risk — similar to the current capital rule’s simple CVA approach — and a standardized measure for CVA risk that includes a new standardized CVA approach and capital requirement based on the basic measure for CVA risk.
  
  • The standardized approach accounts for both credit spread and exposure components of CVA risk and would allow an LBO to recognize hedges for the exposure component of CVA risk.
  • Prior approval from an LBO’s primary federal regulator would be required to calculate the CVA risk capital requirements under the standardized measure for CVA risk.

Timing and Next Steps

The Proposal would require affected banking organizations to begin transitioning to the new framework on July 1, 2025, and to be in full compliance by July 1, 2028.

Of the six current members of the Board of Governors, four voted in favor of the Proposal (Chair Powell, Vice Chair Barr, and Governors Cook and Jefferson) and two voted against (Governors Bowman and Waller), with the two dissenting governors expressing concerns that the benefits of the Proposal did not justify its costs and that the Proposal could reduce international consistency in capital requirements for large, internationally active banks. Critiques from the industry and members of Congress were swift, and we expect a long and active comment process. Comments on the Proposal are due by November 30, 2023.

For additional information about the Proposal, please contact the authors.

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