On consecutive days at the end of last week, the Federal Reserve Board of Governors (FRB), Office of the Comptroller of the Currency (OCC), and Federal Deposit Insurance Corporation (FDIC) (collectively, the Banking Agencies) issued proposed capital rules and liquidity guidance that, together, offer a glimpse into the regulatory framework emerging from the regional bank distress—and high-profile bank failures—of early 2023. Especially given substantial controversy surrounding the capital proposals, predicting what the end state will look like is difficult. One thing is clear from last week’s announcements, however: material changes are on the horizon, especially with respect to capital requirements and liquidity expectations.
Below, we briefly summarize and outline these developments, highlighting initial themes, takeaways, and open questions. We will continue to monitor this space and provide updates as appropriate.
Proposed Changes to Regulatory Capital Requirements
On July 27, 2023, the Banking Agencies released a proposed rule that, if implemented, would bring sweeping changes to the regulatory capital framework for US banks that have at least $100 billion in assets or engage in significant trading activities (the RegCap Proposal). The FRB also proposed a separate measure to increase the capital surcharge (the G-SIB Surcharge) applicable to the eight US banks that qualify as globally systemically important banking organizations under methodology designed by the Basel Committee on Banking Supervision (BCBS).
The RegCap Proposal was years in the making. It would implement international standards adopted by the BCBS in 2017 (the so-called “Basel III Endgame”) and make other changes to capital requirements for banks operating in the US. Although it generally tracks the approach outlined in a July 10th speech by Federal Reserve Vice Chair for Supervision Michael Barr, its release was met with unusual discord—including dissenting votes and heated public statements—among FRB and FDIC policymakers.
Comments can be submitted until November 30, 2023 and neither the RegCap Proposal nor changes to the G-SIB Surcharge will take effect until 2025 at the earliest. We expect fulsome debate in the coming months and meaningful evolution as the final rules take shape. At this early stage, however, three immediate takeaways are clear:
1. Regulatory Capital Requirements Will Increase in the Aggregate.
In discussions regarding plans for implementing the Basel III Endgame, Federal Reserve officials long maintained that their approach would be “capital neutral” – that is, capital requirements in the aggregate would neither increase nor decrease. But by all measures, the RegCap Proposal would result in an overall increase in capital requirements for holding companies and depository institutions, likely in the range of 6-19%.
Coming as it does at a time when US banks hold historically high levels of capital, many industry observers were quick to take issue with a plan that would require even higher capital requirements. A particular concern is the competitive disadvantage US banks could face relative to foreign peers, especially in the EU, which may be allowed to hold less capital against similar assets.
2. Regional Banks Will Face More Stringent Capital Requirements.
In perhaps its least surprising feature, the RegCap Proposal would lower the asset threshold at which the most stringent capital requirements begin to apply – a direct response to the regional bank failures, and emergency federal actions, that occurred in early 2023. Specifically, although it leaves in place “tailoring” categories the FRB adopted in 2019, the RegCap proposal would apply various requirements to firms in the lower-asset categories—most notably, “Category IV” banks with $100-$250 billion in assets—that are currently reserved for larger institutions.
For example, the RegCap Proposal would require a bank with $100 billion in assets and modest trading activities to do three things not currently required: (a) include in regulatory capital calculations unrealized gains or losses in its available-for-sale securities portfolio; (b) calculate risk weighted assets (RWAs) for operational risk using a new standardized approach; and (c) comply with the market risk capital rule that, to date, has generally applied only to larger banks or those with more active trading operations.
Applying more stringent requirements to Category IV firms would remove what has been characterized as a “loophole” that enabled larger regional banks, including now defunct Silicon Valley Bank (SVB), to hold less capital than larger peers, even if they present similar systemic risks. Put differently: the RegCap Proposal would discontinue comparatively favorable capital rules that have applied to regional banks since 2019. Whether, as many suspect, such a change will spark additional consolidation in the banking sector remains to be seen and is an issue we will be watching.
3. Nonbank Financial Institutions and Private Capital Providers Stand to Gain as Costs Increase for Bank Lending and Trading Activities
Speaking just before the RegCap Proposal was released, JPMorgan Chase CEO, Jamie Dimon, predicted that higher capital requirements for banks would unfairly advantage their unregulated competitors, explaining that “This [would be] great news for hedge funds, private equity, private credit. . . They’re dancing in the streets.” And, although the scale is difficult to estimate, a consensus view is emerging that the new rules could create opportunities for nonbank lenders, private capital, and hedge funds.
Both by increasing capital requirements generally and assigning higher risk weights to certain types of exposures (e.g., residential mortgages), the RegCap Proposal could force banks to retreat from capital-intensive lending markets, ceding share to private credit. It also could drive down asset values as banks look to shrink their balance sheets, enabling nonbank buyers to benefit from favorable pricing. We will be monitoring the extent to which private capital providers succeed in leveraging these opportunities in the months and years to come.
Interagency Guidance on Liquidity Risks and Contingency Planning
On July 28, 2023, the Banking Agencies also released an addendum to their 2010 Interagency Policy Statement on Funding and Liquidity Risk Management (the Liquidity Guidance). The Liquidity Guidance expressly references the events of Spring 2023 and the “acute liquidity and funding strain[s]” regional banks and others experienced, recommending that banks proactively, and frequently, assess their sources of funding to prepare for liquidity events, including those that arise “without warning”.
Although the guidance does not impose new obligations or prescribe specific contingency funding requirements, it reminds banks that private funding sources may become unavailable during times of stress and, importantly, encourages use of the FRB’s “discount window” as a source of liquidity. Banks ordinarily avoid discount window borrowings for fear of the associated stigma or, indeed, that supervisory consequences may result. Without mentioning these concerns, the Liquidity Guidance addresses a separate issue that became manifest in the recent period of banking distress: “operational readiness” to borrow from the discount window.
Because banks generally try to avoid using it, treasury management and finance personnel often lack familiarity with discount window procedures and have difficulty satisfying them in the midst of an emergency; it has been widely reported that this may have been the case at SVB. To that end, the Banking Agencies are now encouraging banks to ensure they are “familiar with the pledging process for different collateral types [at the discount window] and […] aware that pre-pledging collateral can be useful if liquidity needs arise quickly.” Further, the Banking Agencies indicated that banks should consider conducting small value transactions at regular intervals to ensure familiarity with discount window operations.
In light of the Liquidity Guidance, banks of all sizes and profiles should consider whether their contingency funding and liquidity risk management plans adequately address discount window preparedness. This will almost certainly be a supervisory priority during near-term examination cycles.