Today the FDIC Board is considering a Notice of Proposed Rulemaking (NPR) that would substantially revise and strengthen the capital requirements applicable to banking organizations with total assets of $100 billion or more, including their subsidiary depository institutions, as well as to other banking organizations with significant trading activity. Requirements under the proposal would generally be consistent with international capital standards issued by the Basel Committee on Banking Supervision, commonly known as the Basel III reforms.
This proposal is a continuation of the federal banking agencies’ efforts to revise the regulatory capital framework for our nation’s largest, most systemically important financial institutions, which were found to be woefully undercapitalized and over-leveraged during the global financial crisis of 2008. Following the 2008 crisis, the FDIC, along with the Office of the Comptroller of the Currency and the Federal Reserve Board, strengthened the banking system through an initial set of revisions to the capital framework. Those revisions raised the quality and quantity of risk-based capital and included the introduction of an enhanced supplementary leverage ratio for our largest, most systemic banking organizations. However, there remain areas of the regulatory capital framework that need improvement.
Today’s proposal would make important changes that will address the capital weaknesses identified in the 2008 financial crisis, enhance the resilience and stability of the banking system, and enable the banking system to better serve the U.S. economy. I would like to highlight several aspects of the proposal that I believe advance this overarching goal.
Risk-Weighted Assets – Credit, Operational, Market, and Derivatives Risk
To begin, the proposal would revise the calculation of risk-weighted assets and limit the extent to which banks can use internal models to calculate minimum capital requirements. At its core, the proposal addresses four critical areas with respect to risk-weighted assets: credit risk, operational risk, market risk, and financial derivative risk.
For credit risk, the proposal would eliminate the use of banking organizations’ internal models to set regulatory capital requirements and in its place apply a simpler, standardized framework. The FDIC has long had concerns about the use of internal models in establishing minimum capital requirements for credit risk because of their lack of transparency and variability of results. The proposed changes would improve the consistency and transparency of capital requirements, and would enhance the ability of supervisors and market participants to make independent assessments of a banking organization’s capital adequacy, individually and relative to its peers.
For operational risk, the proposal would also address the drawbacks of the current, models-based approach, which can produce estimates that exhibit substantial uncertainty and volatility as well as a lack of transparency and comparability. Operational risk generally refers to the risk of loss resulting from inadequate or failed internal processes, people, and systems, or from external events, including cybersecurity attacks. As the size and complexity of a financial institution increases, there are more opportunities for operational risk to emerge. The proposal introduces a standardized operational risk framework in lieu of the existing model-based approach, thereby enhancing transparency and comparability. Operational risk exposures have been, and continue to be a persistent and growing risk for financial institutions, and the introduction of a simpler, standardized calculation for this risk is an important element of the proposal.
With respect to market risk, during the global financial crisis banks incurred significant losses in their trading books— that is their portfolios of instruments traded over the short-term—exposing weaknesses of the existing market risk capital framework. For example, credit markets, in particular those related to structured products like Collateralized Debt Obligations (CDOs), collapsed during the financial crisis. This severely impacted liquidity in these markets. Banks were able to use internal Value at Risk models for these positions even though the models inadequately captured the risks.
As a result, for market risk, the proposal would provide substantial improvements relative to the current framework that are consistent with the goal of enhancing the resiliency of the banking system. The proposal would retain banking organizations’ ability to use internal models for measuring market risk, subject to certain improvements. In particular, the proposal would replace the Value at Risk measure of market risk with an expected shortfall-based methodology that better accounts for potential losses. The use of internal models would also be subject to enhanced requirements for model approval and ongoing performance testing.
These revisions significantly strengthen market risk capital requirements by improving risk capture and requiring banking organizations to demonstrate that their internal models appropriately capture the risk of market risk covered positions. The proposal also includes a new standardized measure for market risk that is risk sensitive and provides comparability across banking organizations. A banking organization may elect to use this standardized method rather than the model-based approach. In addition, banking organizations that do not receive approval to use the models-based measure would be required to use the new standardized measure for market risk.
Finally, risks associated with financial derivative activities are addressed in this proposal by the introduction of standardized approaches for credit valuation adjustment, or CVA, risk. CVA risk refers to potential mark-to-market losses on derivatives transactions resulting from the credit risk of the derivatives counterparty. During the 2008 financial crisis, CVA risk was a major source of losses to bank derivatives portfolios. The revised CVA approaches in this proposal would strengthen the capital framework for CVA risk in a manner consistent with the proposed improvements to the market risk framework.
Scope of Application
A key consideration with respect to these revisions is the scope of application – in other words, which banks are subject to the proposed rule. Historical experience has demonstrated the impact individual banking organizations can have on the stability of the U.S. banking system, in particular large banking organizations. With this in mind, the proposal would apply to banking organizations with total assets of $100 billion or more and to other banking organizations with significant trading activity. Strengthening capital requirements for large banking organizations better enables them to absorb losses with reduced disruption to financial intermediation in the U.S. economy. Enhanced resilience of the banking sector supports more stable lending through the economic cycle and diminishes the likelihood of financial crises and their associated costs including potential costs to the Deposit Insurance Fund.
The proposal would align the calculation of regulatory capital for banking organizations with between $100 billion and $700 billion in total assets with the calculation already applicable for the very largest banking organizations. As a result, all banking organizations with more than $100 billion in total assets would include unrealized losses on securities categorized as available-for-sale in the calculation of regulatory capital. As the agencies have learned from recent experience with bank failures, this change would help ensure that the regulatory capital ratios of large banking organizations better reflect their capacity to absorb losses. In addition, the proposal would lower the threshold for application of the supplementary leverage ratio and the countercyclical capital buffer from $250 billion to $100 billion in total assets. These changes would bring further alignment of capital requirements across large banking organizations, consistent with the proposal’s goal of strengthening the resilience of large banking organizations.
For banking organizations with less than $100 billion in total assets, the revised requirements for market risk would apply if the banking organizations had $5 billion or more in trading assets plus trading liabilities, or trading assets plus trading liabilities equal to or greater than 10 percent of total assets. Notably, the proposal would not change the capital requirements applicable to community banks.
Estimated Impact and Transition
By addressing weaknesses in the existing regulatory framework, the proposal is expected to increase capital requirements in the aggregate. It is estimated that the proposal would increase common equity tier 1 capital requirements by 16 percent for holding companies and 9 percent for insured depository institutions.
It is expected that the impact would vary meaningfully by institution, depending on each banking organization’s activities and risk profile. The majority of banks that would be subject to the proposed rule currently have enough capital to meet the proposed requirements. Staff of the agencies estimated that five large bank holding companies would have shortfalls in their common equity tier 1 capital requirement under this proposal based on year-end 2021 data. For those large holding companies with shortfalls, the amount is estimated to be below one year of average earnings over the last seven years. This means these banking organizations would be able to achieve compliance with these revisions through earnings over a short timeframe, even while maintaining their dividends.1
The proposed changes would be phased in over a 3-year transition period. Any final rule, following careful consideration of comments received, is not expected to take effect until July 1, 2025. Taking the effective date and transition period together, the capital requirements under a final rule would not be fully effective until the second half of 2028. Given the consequence and complexity of this rulemaking, the agencies are providing a 120-day public comment period.
In conclusion, a robust regulatory capital framework is the cornerstone of a resilient banking system. Strong levels of capital available to absorb losses ensure that banks have the ability to continue to lend to their customers through business cycles, including during stress. History has proven that insufficient capital can lead to harmful economic results when banks are unable to provide financial services to households and businesses, as occurred during the 2008 financial crisis.
This Notice of Proposed Rulemaking on Basel III is an opportunity to make important changes to the regulatory capital framework with the ultimate goal of enhancing the financial resilience and stability of the banking system, better enabling it to serve the U.S. economy. I strongly support this proposed rule.
Finally, I would like to thank the FDIC staff for their diligent and thoughtful work in bringing this proposal to the Board today. I would also like to thank the staff at the OCC and Federal Reserve for all their hard work as well.
1 It is worth recognizing that some large banks currently have unrealized losses associated with their available-for-sale securities portfolios that would impact proposed capital levels due to the recognition requirement for unrealized losses under the proposal. The transition period provided under the proposal would support the ability of these institutions to meet the proposed changes over time.