Summary:

Situation Overview: On 27 July 2023, the Office of the Comptroller of the Currency (OCC), the Board of Governors of the Federal Reserve System (Fed), and the Federal Deposit Insurance Corporation (FDIC) jointly published the Basel III Endgame Notice of Proposed Rulemaking (Proposal). The Proposal constitutes a significant shift in bank regulatory policy, increasing capital requirements and significantly altering regulators approach to assigning risk weights. For more on the Proposal’s key elements and unintended consequences, read a previous Patomak Insight here.

What’s at Stake: For months, Chair Powell maintained that there was “a concept of re-proposal,” which the Fed “hadn’t made a decision on.” Unexpectedly, on 1 May 2024, reports emerged that banking regulators were now “pushing to finalize” the Proposal as soon as August 2024.

Expected Outcome: The Proposal has received an unprecedented level of backlash from a wide array of interest groups. The final rule may deviate from the proposal by incorporating:

• A more moderate capital requirement increase;
• Carve-outs for mid-sized banks;
• More nuanced provisions surrounding the use of internal bank models;
• Lower risk weights on certain single-family mortgage loans; and
• A less dramatic macroeconomic impact.

Like the SEC climate disclosure rule, which is being challenged for both exceeding the agency’s statutory authority and for not being comprehensive enough, the final version of Basel III Endgame is likely to face challenges from multiple fronts.

 

Backlash

From its conception the Proposal was steeped in controversy, having been promulgated along partisan lines. The Federal Reserve voted 4-2 to release the Proposal for comment, with Governors Christopher J. Waller and Michelle W. Bowman dissenting. Similarly, the FDIC Board voted 3-2 to release the proposal for comment, with Vice Chairman Travis Hill and board member Jonathan McKernan dissenting. The 1087-page Proposal received 356 comments from major stakeholders – with 97%of them expressing negativity –  figure which Fed Chair Jerome Powell asserted was “unlike anything” he had ever seen. The unprecedented backlash emerged from an unusually wide variety of interest groups, including civil rights advocates, union executives, and energy companies. Moreover, 100% of Republican lawmakers and 93% of Democratic lawmakers opposed the Proposal through comment letters.

The sheer volume and breadth of substantive policy and legal concerns raised by commentors left bank regulators with two options – repropose the rule in its entirety or dramatically alter its scope and substance.

Anticipated Changes to the Proposal

In March, during his testimony in front of the House Financial Services Committee, Chair Powell posited that regulators expected to make “broad material changes” to the Proposal and assured that the final rule would “be one that has broad support at the Fed and in the broader world.”

The Administrative Procedure Act (APA) requires regulators to review all public comments and explain their rationale for accepting or rejecting a suggestion in the preamble of their final rule. While agencies can categorize similar comments in their responses, they cannot ignore evidence and research that contradicts the rule’s purported effects and benefits without violating the APA.

Consequently, market participants can expect the final rule to scale back aspects of the Proposal which received the most negative feedback. These areas include:

Cost of Capital

The Proposal’s 16% increase in capital requirements will, in Governor Waller’s words, force “banks to hold more capital against the services they provide to families and businesses,” which will be passed along in the form of higher borrowing costs. The final rule might mitigate this by easing the overall capital requirement increase, thereby limiting the reduction in liquidity from financial markets.

Capital Requirements for Derivatives

The proposal also includes an increase in capital requirements for banking organizations that provide client clearing services. Industry analysis has found that the combined Basel III Endgame and G-SIB surcharge rules would increase capital requirements by more than 80%, negatively impacting access to clearing and undermining global regulators’ commitment to global clearing mandates. The final rule may scale back this provision, as Chair Powell has asserted that: ”’regulators have a responsibility to ensure that bank capital standards do not unnecessarily discourage central clearing.”

The Consolidation of the Banking Sector

Commenters raised concerns that the Proposal’s burdensome requirements and compliance costs would incentivize mid-sized banks to consolidate to realize economies of scale, thus reducing competition and consumer choice. Consequently, the final rule may create carveouts for mid-sized banks or for banks serving rural or low-income communities.

Mortgage Loan Risk Weights

The final rule may reevaluate the Proposal’s increased risk weighting for certain single-family mortgage loans and the higher capital requirements that many of these loans will face. Commentors worry that these provisions will make home ownership less attainable for low and moderate-income households.

Internal Models

The Proposal eliminates internal bank models in assessing credit risk by eliminating what is referred to as the Advanced Approaches under current U.S. regulation and the Advanced Internal Rating-Based (AIRB) outside the country. Commenters emphasized the importance of internal models for meaningful revenue projections and stress testing tailored to a firm’s individual balance sheet. Consequently, the final rule could establish a more nuanced framework allowing the use of these models in certain contexts.

Macroeconomic Effects

Commentators routinely cited a Basel Committee on Banking Supervision study which found that a 1-percentage-point increase in capital requirements reduces annual GDP by up to 16 basis points, or about $42 billion of output lost per year in U.S. terms. Reminiscent of adjustments made in the final SEC climate rule, the version of Basel III Endgame is expected to reevaluate the most burdensome aspects of the proposal to minimize its overall economic impact.

Legal Challenges

Courts have adopted a test for determining whether a final rule warrants re-proposal. So long as the final rule is a ‘logical outgrowth’ of a proposed rule, further notice and comment on the changes made to the proposal are not necessary.

However, this test places banking regulators in a difficult position. On one hand, failing to fully address commentators’ concerns could expose agencies to lawsuits challenging the final rule as arbitrary and capricious under the APA. On the other hand, the proposal’s extensive economic impact may make it challenging for agencies to sufficiently address commentators’ concerns while still passing the logical outgrowth test.

Major industry players, including the Bank Policy Institute (BPI), are already preparing for legal battle. BPI represents leading banks, and its board includes prominent figures like JPMorgan Chase CEO Jamie Dimon, Bank of America Chairman Brian Moynihan, and Citi CEO Jane Fraser. BPI has recruited industry veteran Eugene Scalia to challenge the rulemaking. Scalia, who has a long track record of successfully challenging agency rulemakings, has asserted that the re-evaluation of the administrative state could be” the defining issue” of the current Supreme Court and that regulators have been “serving up a lot of softballs to the federal courts”.

The target timeline for releasing the final rule will roughly coincide with the Supreme Court’s anticipated decision on the fate of the Chevron Doctrine, which allows agencies to broadly interpret ambiguities in enabling statutes to achieve political victories. West Virginia v. EPA already confined the Chevron Doctrine by ruling that questions of major economic and political significance must have clear authorization from Congress. The extent to which the Supreme Court further confines Chevron will determine whether bank regulators have a sufficient statutory mandate to finalize Basel III Endgame.

Put Patomak’s Expertise to Work

Patomak has deep experience in helping banks and other financial institutions identify and manage risks and respond to developments in banking regulation and supervision. Additionally, Patomak can help financial institutions 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. If you would like to learn more about how Patomak can partner with you, please reach out to the Chair of the Derivatives Practice Group, Jill Sommers, at jsommers@patomak.com or the Executive VP & Chairman of the Banking, Supervision, and Regulation Group, Keith Noreika, at knoreika@patomak.com.