Bank capital is a measure of bank shareholders\u2019 investment in the business. In contrast to deposits or money a bank has borrowed, capital does not have to be paid back. A bank that has sufficient capital can cover customers\u2019 deposits even if the loans it has made aren\u2019t repaid or if its investments drop in value. In other words, it is a cushion or buffer that protects a bank from insolvency\u2014and, thus, reduces the risk that a bank failure triggers system-wide financial instability. As the chart below illustrates, capital is the difference between a bank\u2019s assets (left) and its liabilities (right).<\/p>\n
\t\t\tWho decides how much capital banks must hold?<\/p>\n
Banks decide for themselves, but regulators all over the world require banks to hold a certain amount of capital\u2014calculated as a percentage of their assets\u2014so they are less likely to fail, seek a government rescue, or trigger a financial crisis. If a bank has too little capital, managers may be tempted to take imprudent risks because their shareholders have little to lose if things go wrong and will profit handsomely if things go well. Because capital bears more risk, capital is more expensive for banks than raising funds by taking deposits or borrowing money. So banks want to have just enough capital to satisfy regulators, credit rating agencies, creditors, and shareholders, but no more. In general, the more capital a bank has to have, the lower its profits. Because banks are required to have a set amount of capital for every loan or security they hold, requiring them to hold more capital can make them charge more for some loans. How much more is a subject of debate. But if banks have too little capital to absorb the risks they take, they can, in bad times, trigger economy-wide financial instability. It is clear now that many big banks had too little capital going into the Global Financial Crisis in 2007. Since then, U.S. regulators have increased the minimum amount of capital that banks are required to have. Regulators are now proposing<\/a> further increases in required capital (known as the \u201cBasel III Endgame\u201d), to the dismay of many big banks who are lobbying aggressively<\/a> against the proposal.<\/p>\n What is the Basel Committee?<\/p>\n The Basel Committee on Banking Supervision<\/a>\u2014so named because it meets in Basel, Switzerland\u2014was established in 1974<\/a> to enhance financial stability by improving the quality of bank supervision. It is the primary global standard-setter for the prudential regulation of banks, but it has no legal authority to impose the minimum standards to which the Committee agrees. Adopting rules is the responsibility of the governments of the 26 countries (plus the European Union and Hong Kong) who comprise the committee. The U.S. is represented on the Basel Committee by the Federal Reserve Board in Washington, the New York Federal Reserve Bank, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC).<\/p>\n What is the Basel III Endgame?<\/p>\n Basel III<\/a> is a set of measures developed by the Basel Committee in the years following the global financial crisis of 2007-09. The measures, rolled out over several years, aim to strengthen the regulation, supervision, and risk management of banks. The final set of rules has been dubbed the \u201cBasel III Endgame.\u201d These rules focus on the amount of capital that banks must have against the credit, operational, and market riskiness of their business. In July 2023, the Fed, OCC, and FDIC published for comment proposed changes to bank capital rules in the U.S. that are intended to be aligned with the Basel III standards.<\/p>\n What is risk-based capital?<\/p>\n Since the 1980s, regulators have required<\/a> banks that make riskier loans or investments to hold more capital than banks with less risky portfolios. To do otherwise, the reasoning went, would make no distinction between a bank that made loans to major corporations and bought super-safe U.S. Treasury bonds and a bank that lent to risky ventures or made high loan-to-value mortgages. Banks adjust the dollar measure of their assets to calculate \u201crisk-weighted assets\u201d\u2014a higher number if a bank\u2019s portfolio is deemed risky\u2014and then apply the capital-requirement percentage to that measure. The formula for assigning risks to various types of assets can influence the cost and availability of credit to various types of borrowers. The risk weight for U.S. government bonds is zero because they are considered very safe; banks don\u2019t have to hold capital against that asset. The risk weights for loans to small businesses and homeowners are higher.<\/p>\n What are U.S. regulators proposing?<\/p>\n Many of the changes are quite technical, and this post will touch on only some elements. The proposal fills 316 pages of small type in the Federal Register<\/a>. (An accompanying and less controversial proposal<\/a> that would tweak rules for the very biggest banks is another 18 pages.) Few people besides regulators, executives of banks that would be affected, and their lawyers understand the details.<\/p>\n Regulators say the net effect of the proposal would be to increase the required highest-grade capital (essentially shareholders\u2019 equity plus retained profits) by about 16%<\/a> on average, with a bigger increase imposed on the biggest banks. Put differently, the largest banks would have to hold an additional 2 percentage points<\/a> of capital, or an additional $2 of capital for every $100 of risk-weighted assets. The proposal would change both the numerator and the denominator in the capital\/risk-weighted assets calculation.<\/p>\n Among the major changes, the regulators would:<\/p>\n Apply the stiffest risk-based capital approach to more banks, those with $100 billion or more of assets, up from the current threshold of $700 billion<\/a>. Some 37 large banks in the U.S. would be covered; they hold more than three-quarters<\/a> of all bank assets in the U.S. Community banks and smaller regional banks wouldn\u2019t be affected. Even among the regulators, there is some opposition to the proposals. The Federal Reserve Board voted 4-2 to support them<\/a>, and Federal Reserve Chair Jerome Powell voted in favor of putting them out for comment, but expressed some reservations<\/a>. The vote on the FDIC board<\/a> was 3-2. On both boards, the \u201cno\u201d votes were from Republicans.<\/p>\n What is operational risk?<\/p>\n A substantial portion of the proposed increase in capital is targeted at banks\u2019 operational risks. Operational risk<\/a> refers to the risk of loss from inadequate or failed internal processes, people, and systems, or from external events, including rogue traders, fraud, and big fines for violating anti-money laundering or other laws. Under current rules, only the biggest banks are required to have capital against operational risk; the proposal would raise the requirement for the largest banks and extend it to more banks. Operational risk in the proposal is measured by a \u201cbusiness indicator\u201d based on the size, complexity, and specifics of a bank\u2019s lending, investing, and financing activities and by its history of operations-related losses. \u201cBanking organizations with higher overall business volume are larger and more complex, which likely results in exposure to higher operational risk,\u201d the regulators add. \u201cHigher business volumes<\/a> present more opportunities for operational risk to manifest. In addition, the complexities associated with a higher business volume can give rise to gaps or other deficiencies in internal controls that result in operational losses. Therefore, higher overall business volume would correlate with higher operational risk capital requirements under the proposal.\u201d The impact will be greatest on banks that have large businesses outside conventional lending, such as wealth management and other fee-generating businesses.<\/p>\n Proponents say the changes would give banks an incentive to mitigate these risks. But Fed Governor Christopher Waller says<\/a> that the regular stress tests that the Fed conducts are sufficient incentive to reduce operational risks, and that the proposal would require banks to earmark twice as much capital for operational risks than required by the stress tests. And FDIC Vice Chair Travis Hill says<\/a>, \u201cOperational risk is an amorphous concept, a catch-all category that encompasses a large and highly variable set of risks, ranging from fraud to bad behavior to overzealous enforcement agencies to cyber attacks to asteroids.\u201d\u00a0(Both Waller and Hill voted against the proposal.) The Bank Policy Institute<\/a>, a research and advocacy group for big banks, argues against penalizing banks for past operations-related losses and says the new rules would disadvantage banks with business models that rely heavily on fees.<\/p>\n Which parts of the banking business would be hit hardest by the new rules?<\/p>\n Because of the operational and market risk provisions of the proposal, much of what is driving the increase in the big banks\u2019 required capital are activities outside of simple deposits-and-loans banking, such as trading, market-making, wealth management, and investment banking. Thus, banks with large such operations will be hit harder than those with business models more concentrated on lending.<\/p>\n Specific parts of the proposal will affect particular industries. For instance, companies in the renewable energy business say that the proposed increase in the amount of capital banks are required to hold for certain types of lending to their firms (in the form of \u201ctax equity investments\u201d<\/a>) will dilute the effectiveness of tax incentives for projects aimed at reducing global warming.<\/p>\n What are the major arguments in favor of the regulators\u2019 proposal to increase capital?<\/p>\n The basic argument is that capital is the ultimate protection against bank failures and government bailouts when those failures threaten financial stability. Given the shortcomings of supervision, proponents say that current capital standards don\u2019t adequately address the risks that banks are taking. The regulators say<\/a> that the changes \u201cwould better reflect the risks of these banking organizations\u2019 exposures\u201d and \u201cenhance the consistency of requirements across large banking organizations and facilitate more effective supervisory and market assessments of capital adequacy.\u201d Banks with too little capital may be reluctant to make loans to small businesses and other risky borrowers.<\/p>\n Economists Stephen Cecchetti and Kermit Schoenholtz describe higher capital as \u201can ounce of prevention\u201d against bank failures. \u201cPrevention,\u201d they write<\/a>, \u201cmeans that regulations should limit incentives to risk-taking while also requiring that institutions build in shock absorbers.\u201d Given the shortcomings of supervision and the tendency of policymakers to rescue failing banks, they argue, capital and liquidity requirements should be \u201csufficiently rigorous.\u201d When regulators required banks to have more capital after the Global Financial Crisis, some banks protested that this would hurt their businesses and constrain lending. That didn\u2019t happen. Cecchetti and Schoenholtz wrote in 2020: \u201c[H]igher capital requirements<\/a> have not hurt banks, they have not hurt borrowers, and, if there was any macroeconomic impact, it was probably offset by monetary and fiscal policy. In other words, it is difficult to find any social costs associated with increasing capital requirements and improving the resilience of the financial system.\u201d<\/p>\n Michael Barr, the Fed\u2019s vice chair for (bank) supervision, argues:<\/p>\n \u201c[R]egulatory requirements, including capital requirements,<\/a> must be aligned with actual risk so that banks bear the responsibility for their own risk-taking. The proposal takes an important step toward better aligning capital requirements with risk, both for the specific risks in play this spring [the March 2023 collapse of Silicon Valley Bank and First Republican Bank], and for a much broader set of risks that banks face\u2026<\/p>\n \u201cCapital requirements are\u2026 crucial to our mission of safety and soundness and financial stability. Neither regulators nor bank managers can anticipate all risks, or how risks may be amplified and propagated. Events over the past few months have only reinforced the need for humility about our understanding of the causes and consequences of financial stress, and for an approach to capital regulation that makes banks resilient to both familiar and unanticipated risks.\u201d<\/p>\n Barr said the impact of higher capital standards would be \u201cmodest\u201d and offset by the \u201cgreater resilience\u201d of the banking system which, he said, would contribute to economic growth. Because the bulk of the added capital requirements fall not on lending but on operational and trading activities, Barr estimates that the cost to banks<\/a> of funding the average lending portfolio (and thus the potential hit to borrowers) would rise by only 0.03 percentage point. Better Markets argues that<\/a> \u201cappropriately capitalized banks are strong enough to continue providing credit through the economic cycle, in good times and bad, which keeps the economy growing, creates jobs, and reduces the depth, length, and cost of recessions that large bank failures usually cause.\u201d<\/p>\n At a November 2023 hearing, Sen. Sherrod Brown (D-Ohio), who chairs the Senate Banking Committee, said, \u201cOf course, we know the complaints that are coming<\/a>\u2014in fact, they started before we even saw the proposal. The industry has relentlessly attacked it with the same old tired arguments. Compliance will cost too much, we won\u2019t be competitive, we already have enough capital, we won\u2019t be able to lend to small business. We\u2019ve heard it all before. Let\u2019s be clear: The largest banks will need to re-direct a tiny fraction of their enormous profits over a period of several years to get to the new capital levels.\u00a0Every single bank that would be impacted by this proposal has the capacity to comply with the new capital levels and extend credit to small businesses and working-class and middle-class families\u2014all while remaining wildly profitable.\u201d<\/p>\n What are the major arguments against the proposal?<\/p>\n Critics say it is overkill, will discourage lending, and will push lending and other activities outside the regulated banking system to less regulated institutions to whom the new capital requirements don\u2019t apply.<\/p>\n When Fed Governor Waller voted against the proposal in July, he expressed concern that it would \u201cincrease the cost of credit and impede market functioning without clear benefits to the resiliency of the financial system.\u201d He challenged<\/a> the conceptual approach that the proposal\u2019s authors took:<\/p>\n \u201cAn important question\u2026 is why do banks need to sideline separate buckets of operational risk, credit risk, and market risk capital when those risks are unlikely to manifest at the same time? It is similar to asking individuals to establish separate emergency funds for shocks to their income, such as losing their job, and shocks to their expenses, like a fire in their house or their car breaking down. Households understand it is exceedingly unlikely that they will experience a month where all these shocks hit simultaneously, so their emergency funds are less than the sum of those individual expected expenses.\u201d<\/p>\n Randall Quarles, Barr\u2019s predecessor as Fed vice chair, argues that the banking system is already adequately capitalized. He also says that the proposal<\/a> will drive business out of the regulated banking system to unregulated parts of the system which are less transparent, have smaller capital cushions, and generally aren\u2019t eligible for routine loans from the Fed in a liquidity crunch.<\/p>\n Bank trade associations have been aggressively criticizing the proposals. Recognizing that they won\u2019t win much support by complaining that it will make it harder for them to make money, they argue that it will hurt borrowers and the overall economy. The Financial Services Forum, comprised of chief executives of the nation\u2019s eight largest banks, has a website (americanscantaffordit.com<\/a>) that deems the proposals \u201canother bill Americans can\u2019t afford.\u201d The Bank Policy Institute<\/a> has been pumping out policy briefs criticizing every aspect of the proposals and launched a website called stopbaselendgame.com<\/a>. A centrist political action committee called Center Forward<\/a> (which doesn\u2019t disclose its donors) ran a TV commercial<\/a> during a Sunday NFL game attacking the capital proposals.<\/p>\n The banks\u2019 campaign has had some success. In the Senate, 38 Republicans, including all Republican members of the Banking Committee, signed a letter<\/a> to the regulators in which they said: \u201c[T]hese large increases in capital have not been shown to be evidentially based as the Federal Reserve, FDIC, and OCC have failed to provide proper analysis or data to justify their merits, particularly around the costs they will impose throughout all sectors of the economy. In fact, we have heard widespread concerns regarding the negative impacts that Basel III could have not only on affordable housing but on mortgage lending writ large, small business lending, and consumer lending\u2026 Moreover, the proposal disproportionately harms companies that are not publicly listed, who happen to be middle market, private entities, and our millions of small businesses across the country.\u00a0Each of these potential consequences would have major ramifications alone, but taken in totality, they pose significant harm throughout the economy, particularly in the face of current economic headwinds and tightening credit conditions.\u201d<\/p>\n Some Democrats also have voiced concerns. Rep. Jim Himes (D-CT) told the regulators at a hearing<\/a>: \u201cThe first line of your testimony today was that our banking system is sound and resilient. So a lot of us are struggling to see the clear need for additional capital.\u201d Sen. Mark Warner (D-VA) noted that banks respond to every regulation with cries that it will lead to less lending, but added, \u201cThat Chicken Little approach<\/a> really lessens your cause when this may actually be the time\u2026\u201d He also speculated that tightening capital requirements for banks could push more lending to financial institutions outside the regulatory perimeter.<\/p>\n How would the new capital rules affect mortgages?<\/p>\n The risk weights assigned to some mortgages in the proposal exceed those in the Basel Committee standards. Banks would have to set aside more capital the higher the loan-to-value ratio of the mortgage. They also would have to set aside capital, under the operational risk provision, for mortgages sold to Fannie Mae and Freddie Mac. When the Fed released the proposals, Fed Vice Chair Barr said, \u201cWe want to ensure that the proposal does not unduly affect mortgage lending, including mortgages to under-served borrowers.\u201d And Better Markets<\/a>, a bank critic, notes that banks have been reducing mortgage lending for decades under existing capital rules. But Laurie Goodman and Jun Zhu<\/a> of the Urban Institute have written: \u201c[The] level of capital that banks would be required\u2026 to hold against mortgage loans held in portfolio is excessive, at all LTV [loan-to-value] levels and is likely to further discourage bank mortgage lending. The impact on lending to LMI [low and moderate income] borrowers and communities and to borrowers of color is particularly perverse in the face of efforts by the bank regulators and other government agencies to encourage banks to increase their lending to precisely these borrowers and communities.\u201d<\/p>\n Do the changes address the problems posed by Silicon Valley Bank?<\/p>\n The Basel III standards pre-date the March 2023 failure of Silicon Valley Bank (SVB). SVB, which had assets of about $200 billion, relied heavily on uninsured deposits, which fled very swiftly, and held a portfolio of bonds that sank in value when market interest rates rose. The proposed capital rules require banks to have capital to account for the risks that loans won\u2019t be repaid, for operational risks, and for trading risks. They don\u2019t directly address the risks to banks posed by rapid increases in market interest rates or inadequate liquidity that were the primary cause of SVB\u2019s woes (along with supervisory failures). But the primary reason that uninsured depositors pulled their money out of SVB is that they feared they wouldn\u2019t get all their money out because the bank was insolvent\u2014which is another way of saying it didn\u2019t have enough capital.<\/p>\n The proposal also would require any bank with assets of $100 billion or more to reflect in their capital calculations any gains and losses in portfolios deemed \u201cavailable for sale\u201d as opposed to securities the bank plans to hold until maturity. Current rules require that calculation only for bigger banks.<\/p>\n The Fed is expected to propose some new rules on bank liquidity early in 2024.<\/p>\n What happens next?<\/p>\n Regulators had planned to take comments until the end of November 2023, but banks asked for more time, complaining<\/a> about a lack of transparency and the absence of data justifying the details. In response, regulators extended the comment period<\/a> until January 16, 2024. \u201cWe have already heard concerns that the proposed risk-based capital treatment for mortgage lending, tax credit investments, trading activities, and operational risk might overestimate the risk of these activities,\u201d Fed Vice Chair Barr told Congress in mid-November<\/a>. \u201cWe welcome all comments that provide the agencies with additional data and perspectives to help ensure the rules accurately reflect risk.\u201d<\/p>\n
\nReduce the ability of banks to use their own models for calculating capital requirements for loans and instead require them to use a standard measure.
\nRequire banks to have more capital for risks posed by trading activities and by operations; require them to use standard models instead of internal ones to gauge these risks. These elements account for the bulk of the proposed increase in required capital.
\nRequire any bank with assets of $100 billion or more to reflect in their capital calculations any gains and losses in portfolios deemed \u201cavailable for sale,\u201d as opposed to securities the bank plans to hold until maturity.<\/p>\n