US banks will face stricter capital rules and closer alignment with the final Basel III framework under early proposals linked to the Federal Reserve’s holistic review of capital standards.
The Fed’s vice chair for supervision, Michael S Barr, outlined these and other changes in a July 10 speech that marks a clear inflection point for the regulatory reform of the US banking sector.
Under the preliminary recommendations, US banks will adopt standardised measures to model credit risk, trading risk and operational risk. Still, they could use internal models for market risk as part of their risk-based capital requirements tied to the ‘Basel III endgame’.
According to Mr Barr, the proposals will lift banks’ capital requirements by two percentage points (or an additional $2 of capital) for every $100 of risk-weighted assets. Significant variation is expected across the sector, however. Capital requirements could be much higher for institutions with substantial trading and fee-based activities.
All lenders with at least $100bn of assets will be included in this regulatory capital perimeter, departing from the existing framework covering internationally active banks and those with at least $700bn.
Moreover, banks with assets of $100bn or more must include unrealised losses and gains in their available-for-sale (AFS) securities when calculating their regulatory capital under the proposals.
Tougher stance
Market jitters earlier in the year, involving the failure of some small and mid-sized institutions, have contributed to the tougher capital stance outlined during Mr Barr’s speech.
“The direction of travel for bank capital is pretty clear: it wasn’t terribly surprising that there was going to be a push for higher capital stemming from the turmoil in March,” says Christopher Wolfe, managing director of North American Banks at Fitch Ratings.
But the market’s response to the proposals has not been favourable. The president and CEO of the Securities Industry and Financial Markets Association, Kenneth Bentsent, issued a statement rebuking Mr Barr’s recommendations: “As currently considered, the US Basel III endgame will significantly overhaul the current risk-based capital framework. We anticipate it will increase capital for banks’ trading activities by almost 60%. We fail to see the rationale for such an increase.”
it wasn’t terribly surprising that there was going to be a push for higher capital
Critics, including Mr Bentsen, have also pointed to the negative impacts these updated capital requirements could have on economic growth by constraining banks’ capacity to lend and support capital markets activities such as market-making.
The proposals acknowledge the impact of higher capital requirements, however, with Mr Barr noting that they “may cause firms to change their behaviour and the way that financial services are provided to our economy”.
To address these pressures, a phase-in period is envisaged. According to the central bank’s estimates, affected institutions could generate the required capital through retained earnings over a period of two years.
Other recommendations include new obligations linked to long-term debt for all institutions with assets above $100bn. This measure, according to Mr Barr, would reduce the impact on the Federal Deposit Insurance Corporation’s (FDIC) deposit insurance fund in the event of a bank failure.
Looking ahead, the impact of higher capital requirements — coupled with the Fed’s changing monetary policy stance — could profoundly reshape the US banking sector. Behavioural changes at the organisational and market level could be accompanied by structural shifts as stricter regulatory standards hit smaller banks and provide an impetus for consolidation.
“Some of the regional US banks had a bit of an arbitrage versus the larger banks, but that will start to narrow,” says Mr Wolfe. “There probably will be some consolidation across the banking sector when regulatory and valuation headwinds abate,” he adds.
