On July 27, 2023, the Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation (collectively agencies) published the much-anticipated notice of proposed rulemaking (NPR or the Proposal) seeking public comment on substantial revisions to the capital requirements applicable to large banking organizations and to banking organizations with significant trading activity. This Proposal is heavily influenced by Basel III, a standard introduced by the Basel Committee on Banking Supervision (BCBS), a panel convened by the Bank for International Settlements (BIS) in Basel, Switzerland, which aims to ensure regulators globally apply similar minimum capital standards and builds off prior iterations of the capital rules.

The revisions set forth in the Proposal are aimed at improving the calculation of risk-based capital requirements to better reflect the risks of bank exposures, reduce the complexity of the framework, enhance the consistency of requirements across banking institutions, and facilitate more effective supervisory and market assessments of capital adequacy.

The Proposal is largely centered on revisions to four fundamental components of capital adequacy:

• Definition of Capital
• Credit Risk-Weighted Assets (RWA)
• Market RWA
• Operational RWA

Scope and Impact of the Proposed Rule

The NPR broadly applies to banking organizations subject to Category I, II, III, or IV capital standards, and to banking organizations with significant trading activity. Banking organizations subject to Category III or IV capital standards are most impacted by the Proposal, as the proposed changes reduce the asset thresholds of institutions that would be required to meet the most stringent capital requirements.

The NPR estimates that, as a result of the proposed changes, holding companies subject to Category I, II, III, or IV capital standards would require an increase of RWA by approximately 20%, while Category III or IV institutions would require an increase of approximately 9.5%. As of December 31, 2022, there were 37 depository institution holding companies and 62 U.S.-based depository institutions that report risk-based capital figures and are subject to Category I, II, III, or IV standards. The 37 depository institution holding companies include 25 U.S.-domiciled holding companies (eight in Category I, one in Category II, five in Category III, and 11 in Category IV) and 12 U.S. intermediate holding companies of foreign banking organizations (six in Category III and six in Category IV).

The NPR provides institutions with 120 days to provide comment and the deadline is November 30, 2023.

The NPR cites a three-year transition period beginning July 1, 2025 to provide banking organizations sufficient time to meet their new capital requirements and to develop the reporting and infrastructure requirements. The transition period would extend from the proposed effective date of July 1, 2025 through June 30, 2028 and cover two of the provisions: 1) revised aggregate risk weights; and 2) accumulated other comprehensive income (AOCI).

Key Elements of the Proposal

The 1,089-page Proposal primarily consists of modifications to capital-related calculations surrounding the definition of capital, credit RWA, market RWA, and operational RWA. A key takeaway is that capital requirements for banking organizations greater than $100 billion will be largely homogenized across the four Regulation YY classifications (i.e., Category I, II, III, and IV). More specifically, some rules within the Proposal heighten the current standards applied to Category III (generally $250 billion-$700 billion in total assets) and IV (generally $100-$250 billion in total assets) banking organizations to match the standards of Category I and II banking organizations. This is a significant change for regional banks. The Proposal would not amend the capital requirements applicable to smaller, less complex banking organizations, such as community banks. Foreign banking organizations represent another segment of the industry that is likely to experience increased regulatory requirements, as many of these organizations under $100 billion may cross the threshold for trading activities and would be subject to the proposed changes.

The NPR includes 176 prepared questions, grouped by topic risk area, that the regulators are soliciting feedback on. This significant number of questions covers all aspects of the rule – calculations, definitions, and implementation. Looking at the three key risk areas, 83 of the prepared questions are related to market risk, 50 are related to credit risk, and six are related to operational risk. The fact that almost half of the massive number of questions are in the market risk area demonstrates the significance of this risk area in the Proposal, and where the industry could provide important feedback. The sub-sections below provide high-level details on key changes and modifications.

Definition of Capital

The NPR would require Category III and IV institutions to meet certain standards that are currently only applicable to Category I and II institutions, essentially extending certain requirements to institutions with assets of $100 billion rather than the current threshold of $700 billion. One particularly important change would recognize most elements of AOCI in regulatory capital, most notably unrealized gains and losses on available-for-sale (AFS) securities. The proposed changes would also impact the criteria for minority interest inclusion in capital and apply more stringent requirements around capital deductions (i.e., investments in the capital of unconsolidated financial institutions, mortgage servicing assets, and certain deferred tax assets).

Credit Risk

The Proposal would eliminate the use of internal credit risk models and introduce a new expanded risk-based approach for calculating credit RWA. The proposed changes would also eliminate the ability for impacted institutions (e.g., intermediate holding companies below $100 billion but trading assets exceeding $5 billion or Category IV institutions generally) to elect the current exposure methodology. The expanded risk-based approach would retain many of the current concepts, such as the application of risk-based treatment surrounding some forms of real estate (i.e., pre-sold construction loans, multifamily mortgages, and high-volatility commercial real estate). Compared to the current framework, the proposed changes would introduce a more risk-sensitive approach to the calculation that provides for greater segmentation of credit risk across exposure categories and allows for the application of a broader range of risk weights. For example, the NPR proposes to apply loan-to-value (LTV) ratios when assigning a risk weight to a regulatory residential or commercial real estate exposure where higher LTV ratios would generally increase the risk weighting. The Proposal also increases risk capture for certain off-balance sheet exposures by introducing a new exposure methodology that would modify the credit conversion factors applicable to commitments and redefine the criteria for defaulted exposures.

Additional changes to credit risk relate to equity exposures, securitizations, and credit risk mitigation. Regarding equity exposures, the Proposal would increase risk weightings when applying the simple risk-weight approach. The proposed changes would also eliminate effective and ineffective hedge pair treatment, modify the conversion factor for conditional commitments, increase risk weights applicable to equity exposures to investment firms, and enhance the risk sensitivity of the look-through approaches for equity exposures to investment funds. Although the NPR proposes a new standardized approach for securitizations, the proposed formula remains substantially similar to the existing method. The changes proposed include minor adjustments to reflect delinquencies, level of subordination in the allocation of losses, and heightened correlation and additional risks inherent in securitizations relative to direct credit exposures.

Changes to the application of credit risk mitigants include replacing certain methodologies (i.e., internal models methodology, simple VaR, probability-of-default, etc.) with standardized approaches. The Proposal would also revise the collateral haircut approach by increasing netting and diversification benefits within netting sets, while also adjusting the market price volatility haircuts (e.g., main index/gold increased from 15% to 20%) and introducing floors (or minimums). This change to the collateral haircut approach is quite notable, as institutions will likely be required to increase collateral associated with repo-style transactions and more so if transactions occur with unregulated entities (e.g., hedge funds and private equity firms). Lastly, in connection with the removal of the internal models methodology, the Proposal would revise the definition of a “netting set.” Specifically, the modified definition would exclude cross-product netting sets and remove the ability to recognize cross-product netting when calculating counterparty credit RWA.

Market Risk

The most substantial and material changes to the current rule involve market risk requirements. However, the proposed changes follow the fundamental review of the trading book (FRTB) standards that have been widely discussed and distributed throughout the industry following the Great Financial Crisis. At a high level, the changes would include replacing the current VaR-based measure with an expected shortfall-based measure, replacing the fixed ten-day-business-day liquidity horizon with liquidity horizons reflective of the underlying risk factors to capture risk of less liquid positions, introducing a standardized methodology for calculating market risk, and improving transparency through enhanced disclosures.

The proposed new models-based methodology is aimed at enhancing risk sensitivity by introducing the concept of a trading desk and restricting application of approved models to individual trading desks. Thus, institutions would be required to obtain approval for each individual trading desk prior to using internal models. Additionally, each trading desk where models are used would be required to satisfy either the proposed desk-level backtesting requirements or desk-level profit and loss attribution testing requirements. If a desk fails to meet these requirements, the standardized approach would need to be applied. Although difficult to quantify due to the unique characteristics of an individual institution’s trading activities (i.e., asset classes/products traded, correlations, diversification benefits, etc.), the requirement to replace the internal model approach with the standardized approach would likely increase RWA.

Regardless of whether regulators have approved model use, all institutions would be required to calculate market risk capital requirements under the standardized method. This method would consist of three main components: 1) sensitivities-based method that captures non-default market risk associated with certain risk factors; 2) standardized default risk requirement that would capture losses on credit and equity positions in the event of issuer default; and 3) residual risk capital requirement. This standardized approach would also include three additional components that would apply in limited instances to specific positions including a fallback capital requirement, capital add-on for re-designations, and any additional requirements established by the primary supervisor.

Operational Risk

The Proposal would require all banks subject to Category I – IV capital standards to calculate operational RWA. This represents a material change, as the current requirements around operational RWA exclusively apply to Category I and II institutions. Additionally, the Proposal would replace internal models with a new standardized approach. This standardized approach would be a function of the institution’s business indicator component and internal loss multiplier. The business indicator component would be calculated based on multiple factors, including business volume, lending and investment activities, fee and commission-based activities, trading activities, and other activities associated with the institution’s assets and liabilities. The internal loss multiplier would be based on a ratio of historical operational losses to its business indicator component (subject to a floor of 1). As a result, an institution’s operational risk capital requirement would increase as historical operational losses increase. Similar to the current capital rule, operational RWA would be multiplied by a factor of 12.5.

Additional Changes

The Proposal would modify the credit valuation adjustment (CVA) capital requirements. Although the changes would not impact the scope of institutions, the Proposal introduces a new standardized approach (SA-CVA) that would allow banking institutions to recognize hedges for the expected exposure component of CVA risk. In addition, the Proposal would provide an alternative option, the basic approach (BA-CVA), which would be similar to the current capital rule’s simple CVA approach.

The Proposal would also require Category IV institutions to be subject to the supplementary leverage ratio and countercyclical capital buffer, representing a departure from the current capital rules that exclude such institutions from these requirements.

Unintended Consequences

The changes proposed may result in unintended consequences, potentially through reduced credit availability and access, as well as market efficiency. These increased regulatory requirements, including the likelihood of increased capital and resources expended to ensure compliance, may be shifted to the consumer through increased costs to core banking products and services such as lending. As a result, credit availability may be most felt by those on the margin, or the retail/business customer that is most reliant and further push traditional banking activities into the shadow banking system where regulators have limited visibility, akin to what was experienced in the years leading up to the financial crisis.

The Proposal also reverses much of the tailoring rules of the capital framework issued in 2019. The tailoring rules, which are currently in effect, provide regulatory authorities with the ability to heighten standards for certain institutions based on risk, regardless of asset size. This NPR would undercut these risk-based principles and transition to a more rules-based system that would heavily factor asset size rather than risk profile. This is a deviation from the principles-based system that banking regulators currently apply.

The elimination of the AOCI opt-out, whereby all net unrealized holding gains and losses on AFS debt securities will be reflected in the calculation of common equity tier 1 capital, is very significant. This provision in the Proposal can be perceived as a reaction to the banking failures from earlier in the year. Although this topic warrants discussion, it is unlikely the requirements outlined in the Proposal related to unrealized losses would have prevented the bank failures as liquidity risk was ultimately the driver of failures. Of the banks that failed, unrealized losses on securities was not the main factor. Looking back at Silicon Valley Bank, approximately $15 billion of the total $17.5 billion (85%) in unrealized losses were held within the held-to-maturity (HTM) portfolio as of December 31, 2022. Thus, this provision of the Proposal would not have done much to help the situation at Silicon Valley Bank and could incentivize behavior that limits flexibility and/or increases risk. For example, banks impacted by this change may decide to classify a larger portion of their investment portfolio as HTM. As a result, the ability for these banks to access liquidity through security sales if conditions necessitate may be further impaired.

Another example of unintended consequences can be directly attributed to the market risk provisions in the NPR. The market risk requirements are generally based off the FRTB standards and were originally developed for banks with significant trading activities or trading portfolios. Regional banks with immaterial trading activities will now be subject to the full scope of the market risk requirements. As a result, these banks will now be required to devote substantial financial resources to establish appropriate infrastructure and hire additional personnel.

Put Patomak’s Expertise to Work

Patomak has deep experience in reviewing and assessing minimum capital requirements at domestic banks, large foreign banking organizations, swap dealers, and broker-dealers. Our work has included assessing and identifying opportunities for enhancements to calculating minimum capital requirements, governance and reporting frameworks, and control functions. Additionally, Patomak has worked in assisting firms in managing market risk and operational risk. Patomak has deep experience in helping financial institutions draft and submit comment letters to the OCC, Federal Reserve, SEC, CFTC, and FINRA related to rule proposals.

If you would like to learn more about how Patomak can partner with you, please reach out to John Vivian, Senior Director, at jvivian@patomak.com or Joshua Kuntz, Manager, and jkuntz@patomak.com.