Walls are closing in on the Basel capital reforms

Bloomberg News

WASHINGTON — Groups across the ideological spectrum Tuesday raised concerns with capital reforms jointly proposed by the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corp. and the Board of Governors of the Federal Reserve. 

The diversity of naysayers on the rule was a point touted by the banking industry, whose trade groups have waged an aggressive pushback campaign on the proposal. 

Two of those groups— the Bank Policy Institute and the American Bankers Association — laid out their complaints on the proposal in a lengthy, more than 300 page document on Tuesday. While the leaders of the organizations outlined concerns over potential overlapping regulatory requirements and opaque expectations around appropriate risk weights, they also pointed to other comment letters, notably those written by civil rights and consumer advocacy groups. 

"I don't think in my experience in representing and serving the banking sector, I've ever seen so many disparate groups across the ideological spectrum raise their hands with concerns over rule proposals, ever," said ABA CEO Rob Nichols in a press conference on Tuesday. 

This latest push from the trade groups represents another escalation for the banking industry in its opposition to the rule. While last week, the bank trades made it clear that they believe the rule could be challenged legally, the lengthier letter lays out in detail the extent of the complaints, and gathering the community groups and others serves as an important stepping stone to making their case against the banking regulators. 

The strategy is a relatively novel one in financial policy: "Calls for 'withdrawal or we will sue' is unprecedented post-financial crisis and demonstrates a sea change in the way the bank trade associations are fighting back against this rule," said Edward Mills, a managing director at Raymond James. 

Still, the possibility of legal action is a "last resort," said Greg Baer, president and CEO of BPI, at the press conference. Baer said that it's the position of his trade group, at least, that banking regulators should restart the rulemaking process. 

At the very least, the suggestion of legal action will at least delay the finalization of the rule, Mills said. Other experts, however, anticipate a more drastic course-correction due to the outpouring of opposition to the Basel proposal. 

"The Basel III endgame proposal was always going to be softened, but the total tonnage of opposition to this proposal suggests that we could see a re-proposal rather than a softening through the final rule," said Isaac Boltansky, an analyst with BTIG Research. 

Put it in writing

From civil rights advocates to the nation's largest public pension fund manager, a broad and ideologically diverse array of interests expressed concerns with the second order impacts of the capital reforms in their official comment letters.

The National Community Reinvestment Coalition, which advocates for low- and moderate-income consumers and communities, acknowledged the positive aspects of the proposed rule in its comments. NCRC noted the need for robust capital in the banking system given the role insufficient capital played into the 2008 financial crisis, and said the proposal would fortify banks' resilience throughout stressful economic periods. 

But the group also said that the proposed rule would substantially increase risk-weightings for the kinds of high loan-to-value (LTV) loans that are disproportionately taken out by low-income people of color. Increased risk-weightings — which, they note exceed even the original standards suggested by the Basel Committee on Banking Supervision — would disincentivize banks from making those loans, and by extension could hurt lending in those communities. 

"If risk weightings for high loan-to-value mortgage loans held for investment increase dramatically, it may make banks more hesitant to extend mortgage loans to the types of  borrowers — typically lower-wealth, lower-income, and of color — who make smaller down  payments," the NCRC said in its letter. "The Agencies should adopt the effective but less punitive risk weightings called for in Basel III." 

The National Housing Conference, a consortium of hundreds of nonprofit fair housing and civil rights organizations similarly expressed concerns with the proposal's unintended potential to restrict lending to first-time homebuyers — which are often also high LTV loans — in itscomment letter issued Friday. It notes the significant increase in capital will disproportionately strain homebuyers with limited funds.

"Mortgage credit risk was not a factor in any of the recent bank failures," NHC noted. "The failures were caused by a lack of hedging of interest rate risk for holding long term fixed rate assets, like mortgage-backed securities and U.S. Treasuries at institutions that had extreme sensitivity to a handful of large depositors, well outside of the coverage of FDIC insurance."

Financial inclusion advocates like the Center for Economic Inclusion cited data from a study published by the Urban Institute which suggested the capital reforms would lead banks to impose more stringent lending standards, locking some low income folks out of accessing such products.

"This would exacerbate existing disparities in access to financial resources," the CEI letter said. 

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The Pittsburgh NAACP, Black Leaders Organizing for Communities and the Southern Christian Leadership Conference cited similar concerns.

Not all comment letters submitted were as negative toward the Basel III endgame proposal, however. The proposal received positive comments from a cohort of dozens of top financial scholars Including Arthur E. Wilmarth, Jr. of George Washington University; Hilary J. Allen, of American University; Todd Phillips of Georgia State University; Saule T. Omarova of Cornell University and Anat R. Admati of Stanford University.

The academics expressed support for the federal banking agencies' proposal arguing increased capital buffers would make banks more resilient during economic or financial stress, improve risk management incentives for shareholders and executives, and lower costs to the public when poorly managed banks fail. 

The academics, in their letter, also countered many of the arguments critics of the proposal have made. One such argument the professors responded to was the idea that the proposal might inadvertently increase systemic risks by diverting financial activity to less-regulated nonbanks. 

The academics counter this by noting that preventing migration of financial activity fails to justify allowing large banks to continue operating with insufficient capital. 

On the issue of international competitiveness, the academics pointed to historical evidence suggesting well-regulated U.S. banks outperformed European counterparts after implementing similar rules. 

"U.S. banks' outperformance makes sense precisely because capital makes our financial system strong  and resilient," they wrote. "The real risk to international competitiveness is not stronger capital rules, but rather lax prudential regulation."

Investor advocacy group Better Markets submitted a comment letter saying it supports the proposed changes, emphasizing the need to accurately reflect risk and shift the burden of risk to banks and shareholders. The group said it actually does not go far enough to strengthen capital levels at the largest banks. That's because while the proposal adjusts risk weights for assets on bank balance sheets, it does not strengthen or change the required capital ratio levels that banks are held to maintain. 

"The Proposal makes the calculations of the capital ratios more robust, with changes to better measure the risks banks face that are long overdue, but it does not actually increase the required minimum capital ratios," the group said in the letter. "Bank capital will be better measured under the Proposal, which may lead to increased capital at large banks, but minimum capital requirements will still not have been 'strengthened'."

CalPERS, the California Public Employees' Retirement System, weighed in on the proposal with a comment letter containing both critiques and support. While CalPERS expressed understanding with regulators' apparent intention to limit banks' discretion in setting their own capital levels using internal models, they raised specific concerns regarding the pension weighting in the proposal. CalPERS emphasized that highly regulated, transparent, and low-risk public pension funds — such as itself — should be assigned risk weightings comparable to entities with similar credit risks. They argued against the proposed treatment, which would categorize such pension funds as posing higher credit risks than issuers of publicly traded securities with, they say, actual higher credit risks. 

"The credit risk profile of CalPERS is also very different from many issuers of publicly traded

Securities," the letter said. "The State of California provides unique protections to those doing business with (including providing credit to) CalPERS. We urge you to revise the Proposal to treat highly regulated, transparent, low-risk public pension funds like CalPERS similarly to investment grade-rated entities."

A growing battle over Basel

The banking industry, for its part, has been raising many of these concerns consistently since the proposal was unveiled last July. 

BPI, ABA and other banking trade groups noted in a letter Friday the rule lacked the necessary justification and evidence required by the Administrative Procedure Act and called for the agencies to rescind and re-propose the rule, citing flaws in risk weight assignments, data analysis, and consideration of alternative risk measures. The industry claims rule as proposed, would be arbitrary and capricious — the very legal standard regularly used for mounting lawsuits to block agency rules on procedural grounds, suggesting a lawsuit is not off the table if regulators ignore their concerns. 

"The precise potential impact on capital market liquidity is extremely complex to assess but would likely be significant for several segments of the market, with resulting harm to U.S. businesses, consumers and Americans saving for their retirement," the groups wrote. "Given the stakes involved, the proposal is remarkable for its conclusory assertions and lack of analysis, including its failure to consider both its costs and benefits, not just to banks but to all corners of the U.S. economy."

On Tuesday, the groups released a substantial 314-page letter expanding on their concern the rule will hurt credit availability and the economy. Like previously, they cited a perceived lack of analysis and contended the proposal assigns punitive risk weights to various assets in a haphazard unjustified manner. Additionally, they argue that the proposal fails to effectively address regulators' intent to shore up vulnerabilities exposed in the bank failures of 2023, as these failures were primarily related to liquidity risk rather than the operational and credit risk extensively addressed in the proposal.

"Since 2017, there has been no evidence that U.S. banks hold insufficient capital against the four risks addressed in the proposal," they said. "[Silicon Valley Bank] did not fail due to credit, operational, market or CVA risk: its borrowers repaid their loans; it suffered no cyber-attack or other operational loss; and it did not trade derivatives or securities."

Ian Katz, an analyst with Capital Alpha Partners, said while most of the concerns aired in Tuesday's lengthy letter have been aired previously, the industry has made its point clear. While he thinks the agencies are still unlikely to withdraw the proposal, there will almost undoubtedly make significant changes based on those concerns.

"The regulators are already aware of all, or almost all, of these grievances from the banks," said Katz. "I also think there will be substantive changes in several areas the banks have brought up."

Jaret Seiberg, an analyst with TD Cowen who has said in the past the rule would be pared down before being finalized, said such unified industry opposition only reinforced his view. For bank regulators, he said that withdrawing the rule is a backup plan.  

"The regulators and the banks would still like to bring this process to a close and get certainty for what the capital requirements will be going forward," Seiberg said. "It is why I believe the banks are highlighting changes that could win their support such as sticking to the original Basel III Endgame approaches to credit risk and operational risk."

Federal Reserve Board Governor Waller, speaking at an event at the Brookings Institution Tuesday, also advocated for withdrawing the proposal. While the Fed has been taking steps to address the concerns — including extending comment on a quantitative impact study regarding the proposals' effects, he suggested the proposal may be beyond repair. 

"The blowback we've seen from the banking industry and [Capitol] Hill has shown that this is not necessarily a good rule — proposed rule — as it stands now," Waller said. "So, it's gotta have a major overhaul in my view to get a reasonable product, and possibly just taking it back and starting over."

Katz said in an analyst note that he thinks the regulators will pare back some of the so-called 'gold-plating' of the BCBS standards — that is, bringing it more in line with the international minimum standards. That's a concern even many liberal advocacy groups raised. 

"The fact that Democrats are unhappy about the mortgage and tax-equity parts makes it a pretty sure thing they will be changed," Katz wrote in a note. "We also anticipate changes in the operational risk part of Basel[,] the biggest chunk, accounting for 90% of the increase in banks' capital requirements."