Amid Washington's broader ideological skirmish about the role and effectiveness of bank capital, a narrower, more technical skirmish is playing out over a regulatory requirement aimed at the eight largest, most complex banks in the country.
Proposed alongside the risk weighting reforms known as the Basel III endgame this summer, the Federal Reserve's suggested updates to the global systemically important bank, or GSIB, surcharge aims to align banks' capital requirements more closely with their systemic profile.
The GSIB surcharge is an additional capital charge applied to the eight largest and/or most systemically important banks in the country — Bank of America, BNY Mellon, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street and Wells Fargo — on top of standard capital requirements.
Proponents of the proposed framework say it would be more adaptive to changing risk exposures within banks and prevent so-called "window dressing" — a practice in which banks clean up their balance sheets before year-end reporting deadlines — by requiring banks to disclose exposures based on daily averages, rather than a single moment in time.
For the banks in the GSIB category, the shift would bring with it more operational expenses. But it would also carry the benefit of narrowing scoring bands for determining systemic risk, making the charge each bank faces more correlated to their riskiness and thus eliminating the "cliff effect" — that is, big jumps in capital costs that come with crossing from one band to the next.
"A reasonable argument can be made that, if you're just looking at this change in isolation, that maybe it's not that bad. But, you can never really look at these things in isolation," said Chen Xu, a bank regulatory lawyer with Debevoise & Plimpton. "When you look at everything in the aggregate, it gets a little bit concerning."
Banks and their allies have expressed concern about the calibration of the surcharge, particularly when paired with other regulatory changes under consideration, namely the Basel III proposal for measuring risk-weighted assets. Xu said some exposures could be counted two or three times between the two frameworks, leading to a greater overall capital increase than regulators currently anticipate.
Yet, the greatest concerns about the surcharge changes are being raised by banks that would not actually face the requirement, but still have to complete the corresponding disclosure form, known as FR Y-15, which would also be amended by the proposal.
U.S. operations of overseas banks say the framework's new definition for cross-jurisdictional assets amounts to "targeting," as it would cause several institutions to be moved into more stringent regulator categories.
Two trade groups representing these banks, the Institute of International Bankers and Bank Policy Institute, filed a comment letter with the Fed earlier this month. In it, they criticized the proposal to count derivatives between affiliated entities as cross-jurisdictional assets. Doing so, they argue, puts international banks at a disadvantage to their U.S.-based peers and violates standards established during the Fed's 2019 rulemaking on regulatoring tiering.
"If this re-tiering of international banks is the Federal Reserve's intended result, then this outcome signals a severe miscalibration of the GSIB Surcharge Proposal and the CJA risk-based indicator, and a specific targeting of international banks for more stringent regulation without any policy rationale," the trade groups wrote. "If this result were intended, then the cause of the re-tiering would need to be reproposed, as the Federal Reserve would need to substantiate this result with much more than it has provided in the proposal."
By the Fed's estimation, the new calculation of cross-jurisdictional assets would result in seven banks and two intermediate holding companies being moved from Categories III or IV under the central bank's tailoring framework into the more stringent Category II.
There is some debate about how many banks would actually be recategorized. The proposals were based on data collected by the Fed several years ago and do not necessarily reflect bank balance sheets of today. To address this, the Fed is conducting a quantitative impact study to explore how its various regulatory proposals might be felt by the banking industry. The study includes several categories of information related to the GSIB surcharge.
In their letter, the IIB and BPI note a potentially meaningful discrepancy between the proposed revision to FR Y-15 and the proposed instructions on how to complete it. The instruction notes that banks should not include "liabilities to offices of the FBO outside the reporting group," a change that would exclude the affiliated derivatives and result in no banks being recategorized. The form itself, however, does not call for the exclusion.
"We believe that the Proposed FR Y-15 Instructions provide the proper, and intended, outcome," the groups wrote. "Therefore, the Proposed FR Y-15 Form is incorrect and should be corrected before finalizing."
The Fed declined to comment on the discrepancy between the proposed instructions and the proposed form.
In the proposal, the Fed argues that by omitting derivatives from cross-jurisdictional asset calculations, the current framework understates banks' risk exposures. It also notes that including them in the revised framework will provide "a more accurate and comprehensive measure" of cross-border risk. The Fed also included questions about foreign derivative claims in the impact study it launched in October.
Proponents of the rule change say the inclusion of derivatives in the cross-jurisdictional asset calculation was a needed change. In a joint comment letter, Stanford University professor Anat Admati along with University of Michigan assistant professors Jeremy Kress and Jeffrey Zhang, argued that derivatives function similarly to other included assets and can also transmit distress in the same way.
"Further, omitting derivatives from cross-jurisdictional indicators may incentivize banking organizations to transact with overseas counterparties using derivatives in a form of regulatory arbitrage," they wrote. "Conceptually, therefore, derivatives should be included in measures [of] cross-border activity, just like other cross-border claims and liabilities."
Groups outside the banking sector — including utilities companies, derivatives clearing operations, an aluminum manufacturer and other organizations that deal with commodities — submitted letters opposing the change. They argued that the inclusion of derivatives in the GSIB surcharge calculation will incentivize banks to pull back on engaging in this type of activity, making it less available and more expensive.
The World Federation of Exchanges, a London-based industry association representing exchanges and clearing houses, echoed concerns from IIB and BPI about the Fed's lack of explanation for the changed approach to derivatives.
"No evidence has been provided to suggest that the current proposals will rectify a material issue without causing a profound negative impact on cleared derivatives markets and increase systemic risk," the WFE wrote. "This is important, as under the U S Administrative Procedure Act, agencies 'must explain the assumptions and methodology' underlying a proposed rule."
Overall, the GSIB surcharge proposal received just a fraction of the commentary that the Basel III endgame proposal did, amassing 26 letters compared to 237, according to the Fed's website.
Greg Hertrich, head of U.S. depository strategies at the financial services firm Nomura, attributed the relatively small response to the proposed change to the divided attention of the banking sector and its allies.
"I've been a little bit surprised. I have not heard as vociferous a level of pushback as people might have imagined," Hertrich said. "Part of this might be a derivative of the fact that banks have a lot of other things in the Basel III endgame that they're focused on."
