United States: No "Endgame" In Sight — U.S. Bank Regulators Propose Overhaul Of Capital Standards

On July 27, 2023, the U.S. federal banking agencies released a nearly 1,100-page proposal that would overhaul the U.S. regulatory capital framework for all banks and bank holding companies with $100 billion or more in assets — addressing in one massive rulemaking the requirements of the “Basel III Endgame” package as well as a host of other measures intended to respond to the U.S. regional bank failures of early 2023. This controversial proposal, which has been met with intense industry opposition and threatened legal challenge, would impose capital standards and requirements substantially exceeding those agreed at the Basel Committee level and would extend them to a much larger group of institutions. We highlight below five key things for you to know about the U.S. Endgame proposal and what may come next.

In the wake of failures of Silicon Valley Bank (“SVB”), Signature Bank (“Signature”), and several other financial institutions in early 2023, it became apparent that the U.S. federal bank regulators intended to respond forcefully with new rules and heightened capital standards — particularly for banking organizations like SVB and Signature with $100 billion to $250 billion in consolidated assets. Banking groups of this size, which had generally been regarded as not presenting the same degree of systemic risk as the largest internationally active U.S. banks, had been granted relief from certain aspects of the Dodd-Frank Act through a years-long “tailoring” process led by the Federal Reserve Board (“FRB”).

At the same time, the U.S. regulators, like their counterparts around the globe, were tasked with implementing certain finalizing amendments to the international Basel III capital standards that were adopted by the Basel Committee for Banking Supervision in 2017 (commonly referred to as the “Basel III Endgame”). These internationally agreed amendments to global capital standards included revisions to the risk-weights assigned to certain assets, restrictions on the use of internal models by “advanced approaches” banking organizations, a new framework for operational risk, and various other revisions and refinements to the Basel III framework that was developed internationally in 2011 and initially implemented in the United States in 2013.

On July 27, 2023, the U.S. federal banking agencies released a nearly 1,100-page proposal (the “U.S. Endgame Proposal”) that would overhaul the U.S. regulatory capital framework for all banks and bank holding companies with $100 billion or more in assets — addressing in one massive rulemaking both the requirements of the Basel III Endgame and various other additional “changes in response to the recent banking turmoil in March 2023.” At the same time, the agencies issued a separate proposal to amend the calculation methodology for the “G-SIB surcharge” (i.e., an additional capital charge imposed on the largest and most complex banking groups, atop other capital requirements), the net effect of which would be to move nearly a dozen banking groups into a higher Category for purposes of the FRB's enhanced prudential standards — thereby further increasing capital requirements for those institutions.

Significantly, the U.S. Endgame Proposal would impose standards and requirements substantially exceeding those agreed at the Basel Committee level and would extend them to a much larger group of institutions. According to the FRB, the U.S. Endgame Proposal is expected to result in an aggregate 16% increase in common equity tier 1 (“CET1”) capital requirements for affected bank holding companies.

Accordingly, notwithstanding a broad consensus that the SVB and Signature failures were directly attributable to failures of interest rate risk management, liquidity shortfalls, and runs on deposits arising out of niche business models (including reliance on highly concentrated sources of uninsured deposits for substantially all funding) rather than any type of capital shortfall, the U.S. financial regulators appear poised to implement new capital requirements that would make virtually all forms of lending and investment by covered banking organizations substantially more expensive.

Industry trade associations and others — including dissenting members of both the FRB and the FDIC — have criticized the U.S. Endgame Proposal on many fronts, both substantive and procedural, contending (among other things) that it will reduce the availability of credit to U.S. businesses and consumers and push more lending and investment activity into the unregulated shadow banking sector.

We highlight below five key things for you to know about the U.S. Endgame Proposal and what may come next.

1. The U.S. Endgame Proposal would essentially eliminate the tailoring and calibration of U.S. capital requirements and enhanced prudential standards that had been adopted in recent years, subjecting all banking organizations with $100 billion or more in consolidated assets to a relatively consistent framework of heightened standards, based on the premise that all such institutions pose a systemic risk to financial stability. This represents a pronounced reversal in U.S. financial regulatory policy with significant implications for affected institutions (as well as their competitors).
   
   
2. The U.S. Endgame Proposal would eliminate the advanced approaches framework for counterparty credit risk under the current Basel III regulations and replace it with a new “expanded risk-based approach,” which would effectively constitute a second set of standardized risk weights — more stringent than those required under the international Basel III Endgame standards. Covered organizations would be required to calculate risk-based capital ratios under both the existing Basel III standardized approach and this expanded standardized approach, using the less favorable of the two calculations as the operative ratio. These dual requirements, as well as material changes to market risk calculation methodologies, a new standardized operational risk framework, a new method for calculating credit valuation adjustment (“CVA”) risk, and other revisions to the Basel III framework would likely require substantial investments over a period of years by covered institutions (particularly those in the $100 billion to $250 billion range), first to scope and understand the new rules, and from there to develop and implement new systems and techniques for managing regulatory capital. This is all on top of the increased costs of lending investment that would flow from the heightened capital requirements themselves.
   
   
3. While issued separately, the proposal to revise the calculation methodologies for the G-SIB surcharge likewise would have a material impact on capital requirements applicable to certain banking organizations, in particular those that would be expected to shift from Categories III and IV under the FRB's enhanced prudential standards framework to Category II. These shifts, which the FRB has estimated will affect approximately nine institutions in total upon finalization of the rule (seven foreign banking organizations and two intermediate holding companies) would result primarily from the inclusion of derivative exposures in the systemic indicators for cross-jurisdictional claims and cross-jurisdictional liabilities. The FRB acknowledges in the proposal that this change “would substantially increase the reported value of cross-jurisdictional activity of the combined U.S. operations and U.S. intermediate holding companies of most foreign banking organizations that have combined U.S. assets of $100 billion or more.”
   
   
4. In addition to the costs and burdens of adapting to yet another overhaul of the U.S. capital rules, as noted above, the substantive impact of the U.S. Endgame Proposal is expected to be an aggregate 16% increase in CET1 capital requirements for all affected bank holding companies. According to the agencies, the increase in CET1 requirements will be highest for the largest and most sophisticated Category I and II banking organizations, at approximately 19%, with Category III and IV organizations seeing an estimated 6% increase and intermediate holding companies of foreign banking organizations seeing an estimated increase of 14% in their CET1 requirements. These increased capital requirements would make substantially all lending and investment activity within the regulated bank perimeter more expensive — potentially creating additional opportunities for greater market share among alternative lenders and other nonbank financial institutions.
   
   
5. In addition to objecting on substantive policy grounds — including, not least, that the material increases in capital requirements described above are unwarranted, unduly costly, and will reduce the availability of credit to the real economy — industry organizations and other critics have been vocal that the U.S. Endgame Proposal fails to meet the requirements of the Administrative Procedures Act (the “APA”) and is invalid on that basis. In a joint letter to the agencies on September 12, 2023, the Bank Policy Institute, the American Bankers Association, SIFMA, the U.S. Chamber of Commerce, and other trade groups contended that the Proposal “violates clear requirements” under the APA that the agencies must publicly disclose the data and analyses on which their rulemaking is based. Given the success of other recent APA-based challenges to agency rulemakings, it appears at this stage there is a legitimate possibility that the U.S. Endgame Proposal may be subject to litigation absent substantial revision and/or re-proposal by the agencies.

We are also grateful to Bhavishya Barbhaya, Haanbee Choi, Michal Folczyk, Matthew Gallot-Baker, and Daniel Kim for their contributions to this regulatory update.

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