Fed Basel rules offer upside for banks, but impact unclear

• Key Insight: Parsing three proposals totaling more than 1,500 pages aimed at streamlining the bank capital framework will take time, but early industry reaction suggests the rules are more tailored than previous efforts.
• Expert quote: "A lot of the big-ticket items were addressed, but the devil is always in the details." — Chen Xu, attorney at Debevoise & Plimpton.
• Look ahead: Regulators are accepting public comment on the three proposals through June 18.

The banking industry is reviewing three proposals totaling more than 1,500 pages released Thursday by U.S. financial regulators aimed at streamlining the bank capital framework. While the full impact remains unclear, an initial review suggests the rules are more tailored than previous efforts.

The proposals cover Basel III, the global systemically important bank, or G-SIB, surcharge and revisions to the U.S. standardized approach for calculating capital. Industry reaction suggests the measures could free up capital across the financial system, especially when combined with other regulatory updates, including proposed changes to the Federal Reserve's stress-testing regime. Still, some industry observers warn that easing requirements could introduce risks.

Chen Xu, an attorney at Debevoise & Plimpton, said the Federal Reserve's approach appears to take a broader view of capital calibration, something banks have long sought.

"While [regulators] do make a big deal that there's going to be a 1.4% increase in point-in-time capital requirements, they are also proposing parallel changes to stress testing, which could result in an overall decrease in capital requirements," Xu said.

The three proposals, approved in a 6-1 vote by the Federal Reserve Board of Governors and published in the Federal Register, include several key changes. Basel III would replace dual risk-based capital ratios with a single "expanded risk-based" ratio for the largest banks, known as Category I and II firms. The G-SIB surcharge proposal would revise coefficients in the "Method 2" formula, which calculates surcharges based on size, interconnectedness, reliance on short-term funding, complexity and cross-border activity. Separately, revisions to the standardized approach would recalibrate certain risk weights to better reflect a bank's risk profile.

The Federal Reserve worked with the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency to develop the proposals. They follow a 2023 Basel III plan that drew widespread industry criticism as being overly stringent.

Joe Lynyak, a partner at law firm Dorsey & Whitney, said that the current iteration of the Basel III proposal is more balanced than its predecessor.

"This is certainly a more moderate approach than what happened when the initial proposal of Basel, which was more punitive in terms of the capital levels than Basel contemplated," he said. "So I think the answer is that the banking industry will be happy, and I think we will probably see further attempts to moderate capital."

In a statement prior to the publication of the regulatory proposals, Fed Vice Chair for Supervision Michelle Bowman said they would "meaningfully improve the bank capital framework by addressing duplicative overlaps, matching requirements to actual risk, and comprehensively addressing long-standing gaps in our framework."

Taken together — and combined with proposed stress-testing changes — the measures would reduce Common Equity Tier 1 capital requirements by 4.8% for the largest banks, known as Category I and II firms. Requirements would fall 5.2% for Category III and IV banks and 7.8% for smaller institutions.

Matt Bisanz, a financial regulatory partner at Mayer Brown, said early takeaways include expanded flexibility for certain credit risk transfers without prior Federal Reserve approval and lower risk weights for safer mortgages. Bisanz thinks both will be "a really good thing for the market."

"They seem to get the sizing pretty well and they seem to have tailored it nicely for different sizes of banks, although I'm still getting through some nuances there," Bisanz said.

From the mortgage perspective, Bob Broeksmit, CEO of the Mortgage Bankers Association, issued a statement highlighting that the Basel re-proposal incorporates a number of long-standing priorities for the group.

"It includes more risk-sensitive capital requirements using loan-to-value ratios and the opportunity to consider the recognition of credit enhancements such as private mortgage insurance," Broeksmit wrote. "It also takes important steps to reduce the punitive treatment of mortgage servicing rights and commercial real estate loans."

Still, some provisions could draw pushback. Bisanz pointed to changes affecting commitments to lend — particularly how capital is applied to undrawn credit lines — and less granular risk weights for commercial real estate compared with residential loans.

"These are areas we'll be watching closely to ensure they're treated appropriately," he said.

Banking trade groups including the Bank Policy Institute, American Bankers Association and Consumer Bankers Association issued a joint statement Thursday applauding the prudential regulators' efforts, and adding they will "carefully review the proposal." 

Not all Federal Reserve board members agreed on the proposals. Gov. Michael Barr, the sole dissenter, called the reductions in capital requirements "unnecessary and unwise," saying the G-SIB surcharge and Basel III reforms could be implemented without weakening the capital framework. "Today's proposals, if adopted, would harm the resilience of banks and the U.S. financial system," he said.

Regulators are accepting public comment on the proposals through June 18. Lynyak said industry feedback could lead to further refinements, potentially freeing up additional capital and encouraging lending.

"If risk weights are reduced in key areas, banks will respond," he said. "Lower capital requirements can support increased lending activity."

Stakeholders said it will take time to parse the proposals and understand their full impact.

"A lot of the big-ticket items were addressed, but the devil is always in the details," Xu said. "There's a lot of minor technical things that still probably need to be fixed, and that's the point of recomposing the rule rather than just finalizing it."