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In the wake of the collapse of three significant regional banks last year, the banking industry found itself under intense scrutiny, both from the public and regulatory bodies. Since the Great Recession, which occurred roughly 16 years ago, banks have been on edge, anticipating the finalization of crucial capital rules.
Introduction to Basel III Endgame
The upcoming framework, known as Basel III Endgame (BE3), aims to establish comprehensive requirements for the largest banks. These rules encompass various aspects, such as the amount and type of capital banks must hold and specific guidelines for different loan and security types.
A Glimpse at the Past
The industry has been abuzz with speculation regarding the potential impact of these rules. However, recent recommendations by Michael Barr, vice chair of supervision at the Federal Reserve, have provided some clarity, suggesting a potentially favorable outcome for banks.
Unveiling BE3: A Complex Process
The BE3 framework represents a highly intricate set of capital rules, a culmination of nearly two decades of effort. The ‘III’ in BE3 signifies its succession to the previous Basel I and II frameworks.
Initial Proposals and Reactions
In July 2023, banking regulators released an initial outline for BE3. This proposal, perhaps understandably more stringent after the failures of Silicon Valley Bank, Signature Bank, and First Republic, suggested a potential increase of up to 19% in aggregate common equity tier 1 (CET1) capital ratios for banks with assets exceeding $100 billion. The CET1 ratio is crucial, reflecting a bank’s core, loss-absorbing capital relative to its risk-weighted assets. Higher capital requirements typically reduce banks’ profitability, limiting their ability to return capital to shareholders.
Addressing Unrealized Securities Losses
Another significant aspect of the BE3 proposal was the inclusion of unrealized securities losses in CET1 ratios for most large regional banks, a practice already followed by the four largest U.S. banks. This change aims to provide a more accurate representation of a bank’s capital position and prevent situations where banks might need to sell bonds at a loss to cover deposit outflows.
Industry Pushback and a New Direction
Prominent figures in the banking sector, such as JPMorgan Chase’s CEO Jamie Dimon, vocally opposed the initial proposal. Dimon warned that BE3 could lead to higher interest rates and restricted access to loans for small businesses and mortgages, areas that have seen a shift towards non-banking lenders.
A Shift in Regulatory Approach
The concerted efforts of banks and industry stakeholders seem to have paid off. In a speech on September 10, Barr announced plans to recommend a more bank-friendly version of BE3, excluding banks with assets between $100 billion and $250 billion from most rules, except for the inclusion of unrealized bond losses in their CET1 calculations.
Revised Capital Requirements
The reproposed rules would increase CET1 capital requirements for Global Systemically Important Banks (G-SIBs) by 9%, while other large banks would see a 3 to 4% increase due to the inclusion of unrealized securities gains and losses. The impact on non-GSIB firms would be minimal, with only a 0.5% increase in capital requirements.
A Compromise and Clarity for the Industry
Despite the rise in capital requirements, the banking industry views this compromise as a positive outcome. The inclusion of unrealized losses in CET1 ratios is seen as a logical step, while the revised proposal alleviates concerns about potential harm to consumer loans, such as mortgages.
Benefits for Mid-Sized Banks
This proposal is particularly advantageous for banks with assets below $100 billion and between $100 billion and $250 billion. These banks, like Comerica and Zions Bancorporation, faced a dilemma, as surpassing the $100 billion threshold would have subjected them to significantly higher capital requirements under the initial BE3 proposal.
Providing Clarity for Investors
One of the most significant benefits of this proposal is the clarity it provides to large banks. Regulatory capital proposals can change annually, forcing banks to prepare for potential changes before they are enacted. This uncertainty has led many banks to hold off on activities like share repurchases, as seen with U.S. Bancorp. However, following Barr’s speech, the company announced a $5 billion stock repurchase program, signaling renewed investor confidence.
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