After a lengthy “holistic” review and a spring banking crisis, US bank capital requirements finally face overhaul.

By Arthur S. Long, Pia Naib, Ja Hyeon Park, and Deric Behar

On July 10, 2023, US Federal Reserve Board (FRB) Vice Chair for Supervision Michael Barr delivered a speech that outlined his approach to regulatory reform after the FRB’s nine-month-long “holistic” review of capital standards in the wake of the spring 2023 US bank failures (for more information, see this Latham blog post).

Proposed changes will include strengthening capital standards for a broad range of US banks with assets over US$100 billion. The changes to capital requirements would come as a proposal to implement the final aspects of the Basel III capital accord (the so-called “Basel III Endgame”).

Key Areas of Focus

Potential changes from current rules that Vice Chair Barr discussed include:

  • Credit Risk: Replacement of internal bank models for assessing credit risk with a standardized risk weight approach.
  • Market Risk: Adjustments to banks’ measurement of market risk (the risk of loss from movements in market prices, such as interest rate, equity price, foreign exchange, and commodities risk), including raising model quality standards, requiring firms to model risk at the level of individual trading desks for particular asset classes, and introducing a standardized market-risk approach for use if use of models is not feasible.
  • Operational Risk: Replacement of internal bank models for assessing operational risk (e.g., trading losses or litigation expenses) with a standardized approach that approximates a firm’s operational risk charge based on its activities and adjusts the charge based on historical operational losses.
  • Unrealized Portfolio Losses: Requirements that all banks with assets over US$100 billion account for unrealized portfolio gains and losses on their available-for-sale securities in their regulatory capital calculations. On this score, Vice Chair Barr noted that one of the banks involved in the March 2023 failures had not been subject to such a requirement.
  • Stress Testing: Although Vice Chair Barr stated that the stress capital buffer framework is generally sound, he argued that the FRB should review its global market shock and the stress test’s approach to estimating operational risk so that they provide a complementary lens to risk-based standards on market risk and operational risk. He also said the FRB would seek comments on whether the stress tests, when coupled with new requirements relating to credit risk, market risk, and operational risk, would result in “double counting” of risk.
  • Long-Term Debt: Requirements for all banks with assets over US$100 billion to issue more long-term debt, which could be converted to equity to absorb losses upon bank failure. Vice Chair Barr argued that such holdings would also provide the Federal Deposit Insurance Corporation (FDIC) with additional options for restructuring, selling, or winding down a failing bank.

By contrast, Vice Chair Barr suggested that the following requirements were not likely to be materially reformed:

  • Enhanced Supplementary Leverage Ratio: Changes to the supplementary leverage ratio had been considered (for example, to exclude central bank reserves and US Treasury securities from the denominator of the ratio, and to adopt the same leverage ratio buffer as the Basel Committee on Banking Supervision), but are not likely at this time.
  • Global Systemically Important Bank (G-SIB) Surcharge: Vice Chair Barr said that only technical adjustments may be necessary, such as improving the measurement of systemic indicators, reducing “cliff effects,” and increasing the sensitivity of the surcharge to changes in a bank’s risk profile.
  • Countercyclical Capital Buffer: The countercyclical capital buffer has been set at zero since its adoption, and Vice Chair Barr confirmed that no changes to the current framework are being proposed.

Despite the range of changes suggested, and the application of a lower threshold for the enhanced capital rules to institutions with $100 billion or more in assets, Vice Chair Barr stated that the changes “would principally raise capital requirements for the largest, most complex banks.” He estimated that the new requirements would require the largest banks hold an additional two percentage points of capital and contended that because there would be a transition period, banks would be able to build the requisite capital through retained earnings in less than two years, even while maintaining their dividends.

Opposing Viewpoints

Vice Chair Barr’s approach contrasts with FRB Governor Michelle W. Bowman’s comments in a June 25, 2023 speech, in which she cautioned against increasing bank capital requirements based on incomplete information or erroneous assumptions. She feared that higher capital requirements that are disproportionate to risk could hinder bank lending and diminish the competitiveness of US banks on the international stage (for more information, see this Latham blog post).

Private sector banking industry groups are also generally opposed to higher capital requirements, arguing that they may increase borrowing costs and the cost of credit while reducing competition and credit availability. The argument that large banks are adequately capitalized was also bolstered by the latest round of annual FRB stress tests, which showed that all 23 banks under review remained above their minimum capital requirements in the severely adverse scenario.

The Securities Industry and Financial Markets Association (SIFMA) held a Basel III Endgame roundtable on July 12, 2023, debating the ramifications of higher capital requirements on end-users, capital markets, and the US economy. SIFMA, along with the American Bankers Association (ABA), the Bank Policy Institute (BPI), the Financial Services Forum (FSF), and the Institute of International Bankers (IIB) submitted a comment letter to FRB Chairman Jerome Powell, expressing concern over the “serious issues” that implementation of Basel III will entail. Specifically, the organizations argued that it is important to consider not just the benefits of higher capital requirements but also the negative consequences, such as on “the ability and cost of businesses and individuals to obtain credit and capital and manage business risks.”

On the other hand, Acting Comptroller of the Currency Michael Hsu recently echoed Vice Chair Barr’s comments on bank capital requirement adjustments. “Having strong capital requirements is important,” he said. “It can help promote the economy, ensure a safe and sound banking system, and that is in the interest of everyone.”

What’s Next?

While change may be afoot, Vice Chair Barr emphasized that any proposed changes would not become effective for at least a few years. They would first be subject to the FRB’s notice and comment rulemaking process, and if finalized, banks would be allowed time for transition and implementation.

Latham & Watkins will continue to monitor developments in this area.