In July 2023, the Federal Reserve and other top US regulators, unveiled its own ‘gold-plated’ version of the Basel III norms.
The proposal was, almost immediately, heavily criticised by the US banking industry for going far beyond the Basel accord.
A closer look at some of those regulatory proposals do indicate that the US banking regulators might have overreacted (especially on the ramping up of risk weights on residential mortgages). But some of them ─ related to model and operational risks ─ are spot on despite the criticism, especially when viewed in the context of the failures of Silicon Valley Bank, Signature Bank and First Republic Bank.
All that in a while.
But first, the back story.
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The Basel III guidelines were introduced in response to clear breaks in the regulatory apparatuses around the world during the GFC of 2008.
The crux of the Basel III norms is the CET1 ratio, which in simple terms is the ratio of the bank’s core capital over its risk-weighted assets.
The lower this ratio, the weaker a bank. And vice versa.
Refer image for capital requirements of large US Banks. (Source: www.federalreserve.gov)
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Back to the July 2023 proposals from the US Banking Regulators:
While the proposal does not explicitly raise required capital ratios, it does so anyway through its impact on RWAs.
Consider, Residential Mortgages:
Currently, first-lien loans prudently underwritten, receive a 50% risk weight, while other loans receive a 100% risk weight.
Under the draft proposal, residential mortgage risk weights are set to be 20% higher than international standards.
Think about that: the increased mortgage risk-weights against the backdrop of US mortgages currently tipping the scales at $12.14 trillion (at close of Q3, 2023, source: LendingTree), representing about 70% of the US consumer debt.
Now you get an idea why the proposals have raised the industry’s hackles!
This is clearly an area that might get watered down when the US Banking Regulators release an amended draft.
But there are a couple of points in the current draft that could remain unchanged.
For one, the advanced approaches for calculating RWAs (currently used) could well be replaced with the expanded risk-based approach. Particularly since it looks to standardize the approach towards credit, operational and credit valuation adjustment (CVA) risk.
The other one, among others, that could stay ─ in a classic case of closing the stable doors after the horse has bolted ─ is the removal of the ‘AOCI opt out’ (SVB had opted out of the Accumulated Other Comprehensive Income (AOCI) requirement and hence none of the unrealized losses from its available-for-sale securities, largely USTs, were included in its capital).
While awaiting the regulator’s revised draft, safe to say that the US Banking Industry is on tenterhooks, sweating buckets, while enduring the long wait until August ─ a month fittingly referred to as summer’s last stand.
