The federal reserve has responded positively to industry concerns about the 2023 Basel III endgame proposals.
Speaking on September 10th 2024, Michael Barr, Vice Chair for Supervision of the Board of Governors of the Federal Reserve System (the FED) acknowledged that a large number of comments had been received following the 2023 Basel III endgame proposals. Representatives of the FED had engaged in a wide range of industry discussions with stakeholders and organisations such as ORX to understand these concerns.
Barr announced that the board had concluded that “broad and material changes” to the proposals were warranted.
Basel endgame will be re-proposed
Vice Chair Barr stated that he intends to recommend that the board re-propose the Basel endgame and G-SIB surcharge rules and his speech detailed the changes which covered all major areas of the rules: credit risk; operational risk; and market risk.
Little was said around the timeline for implementation though Barr did make it clear that following the re-proposal, there would be a consultation period, providing an opportunity for the public to fully review the changes and provide comment, meaning the current implementation date of July 2025 looks increasingly unlikely.
Three of the changes announced will impact the operational risk component of the capital. Namely, the removal of the ILM; a change to the treatment of fee income; and reduced capital for investment management firms. These changes are likely to be met positively by US banks though it will be interesting to see if and how regulators in other jurisdictions will respond.
Removal of the ILM
Vice Chair Barr will be recommending that the operational risk charge will no longer be adjusted based on a firm’s operational loss history. The stated rationale behind this was to reduce fluctuations in a bank’s operational risk capital over time. The floor of 1 which had been intended for the ILM meant that even firms with a low level of historic loss would not benefit from the inclusion of loss history in the calculation. Thus, we would expect this change to be universally welcomed. Our latest Capital Benchmark Study suggests that the typical size of the ILM for US firms is around 1.07 meaning that including the ILM would result in a 7% increase in capital.
Restatement of the services component expected
One of the areas in which we witnessed significant industry advocacy concerned the treatment of fee-based income as part of the calculation of the services component of the business indicator. In the calculation of the BI, interest and trading income are measured on a net basis while fee income (measured as part of the services component) is not. With a high volume of service-based business in the US, the industry felt this would put them at a disadvantage. Vice Chair Barr has responded to this by announcing his intention to recommend that fee income will be calculated on a net basis rather than a gross basis. The stated rational for this was to allow greater consistency in how op risk is measured across bank activities.
This change will be a significant deviation from every other major jurisdiction which may result in pressure on other jurisdictions to follow.
Reduced capital for investment management
Vice Chair Barr acknowledged that there is evidence that investment management activities typically have smaller historical losses relative to income. Firms with consistently low losses might expect to measure an ILM below 1 and the floor of 1 in the original endgame proposals would have resulted in no capital benefit due to the low loss (as originally intended in the 2016/2017 BCBS proposals). Barr did not however indicate how this reduction would be calculated.
Smaller banks no longer expected to be subject to the rule change
Under this re-proposal, smaller firms will no longer be subject to the endgame changes. The original 2023 proposal included firms with assets between $100Bn and $250 billion in the new capital regime even though these firms would not currently be expected to have an AMA model for operational risk. In his speech, Barr stated that the operational risk rules would not apply to firms with assets below $250Bn allowing less complex firms to maintain a simpler capital framework.
No news on the timeline for implementation
We watch and wait for further information about the expected timeline for implementation. US banks are currently working towards a July 2025 implementation date though with a period of consultation expected for this re-proposal, that seems unlikely.
In other regions, the Bank of England has postponed the implementation of its Basel 3.1 package to January 2026.
The EU however appears to be continuing with its January 2025 start date although the package relating to FRTB has been pushed back by one year amid concerns that the US would not reach an implementation until 2026.
Possible reaction in other jurisdictions
It will be interesting to see how Barr’s speech and the full detail of the re-proposal (when we see it) will influence other jurisdictions. Regulators may feel the pressure to review the services component – particular regions with a high proportion of service-based firms.
We already see a lack of global alignment around the ILM. For those regions which have already implemented the new standardised approach, we see Canadian firms including the ILM while Australian firms exclude it. In regions which are yet to implement we expect the ILM to be included in jurisdictions such as Switzerland, Brazil (albeit with smaller loss component scalar), South Africa (where an ILM floor will be included), Japan, Singapore. Meanwhile we expect the UK and the EU to be excluding the ILM.
The future of US stress testing uncertain
Vice Chair Barr’s speech is likely to fuel speculation that changes may be coming for CCAR. Barr said that the board would be looking carefully at how the stress tests complement the risk-based capital rules citing the combined benefit and burdens.
ORX research suggests the annual CCAR exercise has become a well-embedded activity and that firms are increasingly finding the outputs and the process worthwhile for broader business use. This topic and others will be discussed at the upcoming CCAR roundtable for ORX members and subscribers in New York on November 14th.
