FDIC Chair Martin Gruenberg spoke about this the other day:
After the 2008 financial crisis, banks were found to be undercapitalized and over-leveraged, leading to a complete overhaul of capital requirements through a set of rules known as Basel III.
- The aim was to ensure banks held enough capital to weather economic storms.
- However, Basel III is not yet complete, with a few key updates in the works.
- These changes mainly target four areas of risk: credit, market, operational, and those associated with financial derivatives....
- Credit Risk: Basel III is pushing to introduce a standardized approach for assessing credit risk. The goal here is to make sure all banks are measuring this risk in the same way for greater transparency and comparison.
- Market Risk: The global financial crisis revealed weaknesses in how banks calculate risks associated with short-term trading (trading book). A new set of rules (FRTB) is being introduced to better manage these risks and limit the extent to which banks can use their own internal models for calculations. This should prevent underestimation of risk and undercapitalization.
- Operational Risk: Basel III plans to replace the model-based approach to operational risk (risks related to internal failures or external events) with a standardized approach adjusted for each bank's historical loss experience.
- Risk Associated with Financial Derivatives: Basel III also aims to improve how banks estimate the risk from changes in the value of derivative instruments due to the deteriorating credit worthiness of a counterparty (CVA risk). This was a major source of losses during the 2008 crisis.
Who these new rules will apply to is yet to be decided. For instance, regulators are considering whether they should apply to banks with assets over $100 billion.
- Gruenberg uses SVB as an example for why Basel III needed for banks over $100 billion.
SVB experienced a loss of market confidence, which led to a run on the bank (where depositors try to withdraw their funds all at once due to fears of the bank's insolvency), largely due to the sale of assets at a significant loss.
- This action raised questions about the bank's capital adequacy.
If the unrealized losses on SVB's securities (which were only recognized once sold) had been required to be recognized in capital under the Basel III framework, the bank would have had to hold more capital against these assets.
- This might have prevented the loss of market confidence and the subsequent liquidity run, as it would have given a more accurate picture of the bank's financial health.
Some have suggested that because Basel III will raise risk-based capital requirements, leverage capital requirements (that don't consider risk) should be lowered.
- However, the Gruenberg states the FDIC believe both types of capital requirements work together to provide a stronger foundation, ensuring banks hold enough capital and have incentives to manage risk.
This will be slow walked even more!
As I indicated, the federal banking agencies will shortly act on a notice of proposed rulemaking. A final rule is not likely to be acted on before the middle of next year. Once a final rule is acted on, the implementation period once the rule takes effect would be several more years.
In other words, the impact of the rule on the banking system is not likely to be felt for several years, and that impact would be phased in gradually.
- OPEN meeting 1:00 p.m. on Thursday, July 27, 2023 to discuss proposed rules to implement the Basel III endgame agreement for large banks and adjustments to the surcharge for U.S. global systemically important banks.
- Meeting accessible via www.federalreserve.gov the day of.