Why the Basel III Endgame Must Be Re-Proposed

Highlights from SIFMA’s Basel III Endgame Roundtable

In this episode of The SIFMA Podcast, SIFMA’s Joseph Seidel and Dr. Peter Ryan identify and discuss three key takeaways from SIFMA’s recent Basel III Endgame Roundtable. The Basel III Endgame package of reforms:

  1. Is unprecedented in its scale and scope and deviates from its original intent;
  2. Must be re-proposed in full for both substantive and legal reasons; and
  3. Must be subject to wide-ranging and material revisions that also take into account the proposal’s interactions with other elements of the U.S. capital framework.

In their discussion, they highlight remarks from the Roundtable’s diverse group of regulatory, academic and business participants. They cover the proposal’s implications for the U.S. capital markets, end-users, and broader economy, and the prospects for material changes to the proposal, particularly its trading book-related components.


Edited for clarity

Joe Seidel: Thank you for joining us for this episode of SIFMA’s podcast series. I’m Joe Seidel, SIFMA’s Chief Operating Officer. I’m joined today by my colleague, Peter Ryan, Managing Director, and Head of International Capital Markets and Strategic Initiatives, to talk about the main takeaways from our April 18th Roundtable to discuss the Basel III Endgame proposal, its implications for the U.S. capital markets, end-users, and broader economy, and the prospects for material changes to the proposal.

There’s much to talk about so let’s jump right in. We were fortunate to have a truly outstanding and diverse group of current and former senior policymakers, academics, and leaders from both sell and buy-side firms, as well as other end-user groups participating in the discussion. Peter, what were some of your main takeaways from the Roundtable?

Peter Ryan: Thanks Joe. Well, it was a lively and vibrant discussion that covered a lot of different ground, but there were a few consistent themes. One was just how unprecedented this proposal is in its scope and scale, and how it deviates so clearly from the original intent of the internationally agreed Basel III reforms. As Fed Governor Miki Bowman and former Fed Vice Chair for Supervision Randy Quarles, noted, the reforms were originally intended to be more-or-less capital neutral, with the goal of improving the comparability of capital ratios across banks and across jurisdictions rather than further raising what are already historically high capital levels for the largest banking organizations. But the proposal has deviated very far from its initial design and goals, and really represents a break with past international capital standard setting efforts in terms of both its scope and scale, as former OCC Chief Counsel Julie Williams also observed.

That brings me to a second topic that was mentioned throughout the Roundtable: the need for a re-proposal of the Basel Endgame rule. Most of the participants brought up the need for a re-proposal in their remarks. Both Governor Bowman and former FDIC Chair Jelena McWilliams noted that the response to the proposal has been overwhelmingly negative – you know, 97% of the comment letters that were filed being critical of the proposal, with many of those letters also calling for a re-proposal of the rule. Let’s hear what Governor Bowman had to say about a potential re-proposal:

Governor Bowman: I think the important thing here is that and the Federal Reserve has a great reputation for its credibility, and if we want rules that continue to be durable throughout political cycles, throughout economic cycles, we have to do our homework, prepare proposals that make sense, that don’t have unintended consequences or at least address those unintended consequences and bring something together to at least our board that can be broadly supported. So, I look forward to that and I hope that the next step is a re proposal.

Peter Ryan: So, Governor Bowman is really emphasizing the importance of gaining a better understanding of the impacts of this complex proposal and obtaining broader support across the spectrum for the final package of reforms. Joe, what were your takeaways on the topic of a rule re-proposal?

Joe Seidel: As you know, senior policymakers have publicly acknowledged that they have more work to do and have stated that they plan to make broad and material changes to the proposal given the growing evidence – including from our own recent industry quantitative impact study – that these dramatic capital increases will result in very negative impacts on a wide range of markets, businesses, and consumers.

Several participants observed that the only way to make broad and material changes would be through a full re-proposal of the rule. I thought former Fed Vice Chair for Supervision Randy Quarles’ remarks were notable on this topic:

Randy Quarles: And finally, yes, I don’t think this proposal can be changed enough to make it workable without it being changed enough to require a re-proposal under the Administrative Procedure Act. So it’s not so much is it wise, I don’t think they can do what is wise without doing what it will legally require them to do.

Joe Seidel: Similarly, Julie Williams had an interesting take on the legal requirement facing the agencies. Let’s hear briefly from Julie:

Julie Williams: In order to address the sorts of issues that we’ve been discussing today, I think a re-proposal is necessary, required. If they tried to go ahead without doing a re-proposal, I would be happy to take odds with anybody that would want to do a bet on whether there would be litigation and who would win.

Joe Seidel: So, the vast bulk of the Roundtable participants agreed, either as a matter of good policymaking and/or from a purely legal point of view, that the agencies need to re-propose the rule in full order to make the types of broad and material changes that are necessary.

And as Morgan Stanley’s Andrew Nash noted during the Roundtable’s second session, it is important that re-proposal be clear on the specific problems that each reform is trying to solve for and consider the “second order” impacts of the changes on the cost of financing and risk hedging activities, as well as on the economy as a whole.

Peter Ryan: That’s a great point and relates to another important takeaway from the Roundtable discussion: the importance of basing any proposed reforms on a proper cost-benefit and quantitative impact analysis that considers the full range of potential market and economic impacts arising from the proposal. There was pretty much consensus amongst the RT participants – including in comments by Governor Bowman and former Fed Governor Randy Kroszner and – that the agencies should have conducted this type of exercise prior to issuing the proposal.

Now, the agencies ultimately conducted a QIS analysis after the proposal was issued, and the analysis of those results are expected to be published in the coming weeks. But the industry has already conducted its own granular QIS exercise based on similar data to the agencies’ exercise. Joe, what were some of the big-picture impacts that the industry QIS showed?

Joe Seidel: The industry QIS that SIFMA facilitated with ISDA and input from the eight largest U.S. banks found that the proposed Fundamental Review of the Trading Book (FRTB) and the revised credit valuation adjustment (CVA) framework would result in a 129% increase in market-risk and CVA risk-weighted assets versus current levels, with aggregate capital levels for those banking organizations increasing by around 30% over current levels.

And that is going to have a significant and broad-reaching impact. As Jelena McWilliams noted, the U.S. capital markets provide 75% of the financing for non-financial corporates and intermediate the hedging activities of these corporates. Such dramatic capital increases would undermine market liquidity and vibrancy and would increase costs and reduce choice for businesses, consumers, and government entities that rely on U.S. capital markets for the vast majority of their funding. In turn, this would have adverse effects on U.S. businesses, households, and taxpayers, and negatively impact U.S. economic growth.

Peter Ryan: Thanks for that helpful overview of the QIS results and some of the big picture impacts it revealed. The Roundtable featured some excellent discussions of those impacts, particularly those arising from its trading book components, such as the FRTB, CVA and SFT components of the reforms.

But before we turn to those, I want to ask you about another key theme raised throughout the Roundtable: the overlap between this proposal and the stress testing regime, as well as other elements of the broader prudential framework. What did the participants have to say about those interactions?

Joe Seidel: Many of the participants spoke about the ways in which the proposal would overlap or duplicate other elements of the existing capital framework. As many participants noted, the capital increases I just spoke about are likely to be even greater given the over calibration that arises from capturing similar risks once under the new proposed framework and then again under the Federal Reserve’s stress testing regime.

One of the most important overlaps is between the FRTB component of the proposal and the Global Market Shock or GMS component of the stress tests. As John Rogers [from Goldman Schs & Co.] commented:

John Rogers: Both of them capture the risk of losses a bank could face, in a severe market downturn, both capture losses for market risk, both estimate losses that are based on extreme tail events, both are calibrated to similar historic losses, and both limit recognition of credit risk mitigation and also portfolio diversification.

Joe Seidel: This over calibration also occurs in other areas, as Citi’s Kevin Bailey highlighted:

Kevin Bailey: Looking at market risk and CVA risk, those risks are capitalized twice. I mean through the fundamental view of the trading book and the Standardized Approach to Counterparty Credit Risk, SA-CCR, and second, through this stress testing framework and the global market shock, that John just highlighted. Op risk is a similar application or a double count or overlap by looking at the application of an op risk loss assessment both in the ERBA to the new standardized approach to operational risk, and second, through the stress testing regime.

Joe Seidel: And then there are broader interactions with other elements of the capital and prudential framework. Throughout the Roundtable, there was an extensive discussion of the compounding impact of the GSIB Surcharge proposal on the Basel Endgame reforms, particularly in areas such as client clearing. Randy Guynn, amongst others, also highlighted how the Basel proposal was closely tied to the banking agencies’ long-term debt proposal, which essentially would result in a form of double capitalization for many firms.

Peter Ryan: Those are very important points. Did the participants talk about potential solutions to those over calibration problems?

Joe Seidel: Absolutely. One common theme raised by nearly everyone was the importance of conducting a comprehensive evaluation of how the proposal would interact and overlap with other prudential requirements, particularly the stress testing framework, as well as the GSIB Surcharge and long-term debt requirements. Others also mentioned non-capital requirements, including liquidity rules and resolution planning. So that sort of “holistic review” is crucial if regulators are to get these reforms right.

Second and more specifically, we discussed ways to address the over capitalization of risk between the proposed reforms and the stress tests. For market risk, one approach would be to apply the FRTB to the trading portfolio on a post-GMS shock basis. The Federal Reserve could also apply the Stressed Capital Buffer’s (SCB) annual stress to the U.S. standardized approach to avoid over capitalizing the CVA and operational risk measures which are already captured under the alternative, expanded risk-based approach.

Peter Ryan: So, taking a holistic view of how this proposal interacts with other elements of the prudential framework is clearly going to be crucial in mitigating some of the adverse effects of the proposal.

Switching gears: there were extensive discussions during the Roundtable about the impacts of the proposals on the capital markets and specific end-user groups, as well as solutions to specific problems in the proposal. I thought Dylan Walsh from Oliver Wyman did a good job in summing up some of the overall impacts of the trading book reforms:

Dylan Walsh: We expect to see a few things play out in the market. I think one is there will be reduced levels of credit and liquidity provision from these institutions. It just stands to reason that if you have to hold more capital, and these institutions probably have a limited budget for how much more capital they can put against their activities. They will reduce some of the activity, and then there’s a question of does it go away completely, or does it go elsewhere? And we see, you know, certainly some avenues for it to go elsewhere, but those are going to be players in the non-banking sector who have a very different view of providing liquidity through crisis periods, stress periods, and through the recovery.

Peter Ryan: Even Darrell Duffie, who expressed his broad support for many of the proposed changes, felt that the trading book changes would have an adverse impact on market liquidity during the initial implementation phrase as banks pull back from certain activities as their capital costs go up. Similarly, Andrew Nash talked about the big picture consequences of raising market risk (FRTB) capital:

Andrew Nash: Effect number one is an increase in cost… If you have the effect of raising requirements for certain trading book activities, there’s a transmission effect that results in higher costs for end users and consumers. The second effect or potential effect is investors simply don’t invest or don’t hedge their risks, and so the relative cost of taking out insurance or taking an interest rate hedge is an economic calculation, and if you simply get to a point where it’s no longer economic to make that risk mitigating or investing decision, you’ll simply forego it. The third, which has also been alluded to this morning, is the possibility that more activity migrates from the banking sector to the non-banking sector.

Peter Ryan: Susan Joyce from Alliance Bernstein similarly talked about the impact on asset managers of the proposed changes:

Susan Joyce: Like a lot of the people who’ve spoken already today, we worry that the ripple effects across the banking business will force all banks and others to reconsider allocations to capital intensive businesses. The impact of this move may result in reduced competition, concentration risks, higher fees, and lower liquidity for our clients.

Peter Ryan: So, the bottom line is that trading book reforms – particularly the FRTB component – is likely to push up costs for market participants, lead to a decrease in the availability of core capital markets services like hedging, and potentially result in the migration of activity to other types of firms that may not have the same incentives to act as market makers and provide liquidity during periods of stress. Joe, beginning with the FRTB, what steps did the Roundtable participants suggest regulators could take to mitigate some of the proposal’s likely negative impacts?

Joe Seidel: That’s a great question. On the FRTB specifically, there are a number of potential fixes that were discussed during the Roundtable.

First, the participants suggested that regulators should give greater credit for diversification and hedging activities that under both the FRTB’s internal models & standardized approaches in order to better align with actual risk exposures and reward good risk management practices.

Second, the regulators should make reforms that make it economically viable for banks to use the more risk sensitive internal models approach or IMA. Greater use of internal models would allow for greater risk diversification between banks and would reduce some of the FRTB’s most adverse impacts on key funding markets and end users.

One crucial area is the “non-modellable risk factor” or NMRF component of the FRTB. Andrew Nash did a great job of talking about this during the Roundtable, but in brief the NMRF is designed to apply an additional capital charge where there is a lack of market data – such as in a thinly traded corporate bond market – and thus greater difficulty in accurately modeling risks.

The problem is that this will make it more expensive for smaller corporates with less frequently traded bonds to raise financing and will also make a whole host of other products – such as currency swaps – more expensive. The solution here would be to rescale or reduce the role of the NMRF in calculating a desk’s IMA RWA to reduce these impacts.

The other critical change relates to the profit and loss attribution test, which is offered referred to as the “PLAT.” PLAT is essentially a screening test (alternately a back test) that determines whether a model is fit for purpose and eligible for IMA treatment – if a desk does not pass it, it must use the less risk-sensitive (and more capital intensive) standardized approach. During the Roundtable, there were questions over whether the PLAT as currently designed is actually well suited to US markets and US banks, and more generally whether many banks would be able and willing to invest the resources in building their PLAT modeling capacities. That is why SIFMA has said that the PLAT should be used as a qualitative or supervisory tool rather than a strict test for IMA qualification.

Without changes to the NMRF and PLAT, very few banks will be able or willing to invest in the expensive modeling and testing infrastructure required to implement the IMA; indeed, the signals from some other countries, such as Japan, are that major banks are deciding against adopting the IMA because of these significant burdens.

As several of the Roundtable participants noted, would be an unfortunate outcome, resulting in more homogenization and less risk diversification amongst banks, as well as increased costs for a wide variety of market participants.

Peter Ryan: Thanks for that Joe. Another topic that was brought up throughout the Roundtable was the impact on derivatives products resulting from proposed Credit Valuation Adjustment or “CVA,” as well as impacts on derivatives arising from the FRTB and the separate GSIB Surcharge proposal.

Both the FRTB and CVA reforms could impact the cost and availability of derivatives products that end-users, including non-financial corporates, use to manage risks such as interest rate and FX risks, while the GSIB Surcharge reforms would lead to an increase in the cost of centrally cleared derivatives. What did the participants have to say about these proposed reforms?

Joe Seidel: The Roundtable participants raised concerns about increased costs of hedging activity, reduced availability of derivatives products, and increased concentration risks because of the proposed reforms. They also raised concerns about competitive disadvantages for US businesses. Dylan Walsh suggested that some derivatives activity:

Dylan Walsh: Is just frankly going to stop. The economics of it are going to become unattractive and it won’t happen anymore. It may also become too expensive for end users, and that’s another way of making it stop. I think some activity will become heavily, heavily concentrated in just a handful of the largest institutions who can continue to afford to provide this business.

Joe Seidel: Michael Winnike from BlackRock highlighted the asset management industry’s concerns about the potential impact on client cleared derivatives activity, which has been promoted by regulators since the last financial crisis as a means to reduce systemic risk:

Michael Winnike: It just doesn’t make sense for policymakers to disincentivize clearing by imposing capital requirements that will materially increase those costs, and the estimates are that the Basel III Endgame proposal, along with the G-SIB surcharge punitive impact could increase capital requirements by about 80% for these businesses, and that’s a large enough amount that it would be passed on to end users. But we also have concerns, not just about cost, but about the systemic risk implications. If banks exit the agency clearing market, we are concerned that that could further concentrate risk among a smaller pool of clearing brokers, which could undermine, you know, key default management tools like porting in the event of a default or leave market participants on the sidelines unable to hedge risk if they don’t have sufficient access to these markets.

Joe Seidel: Adam Gilbert from PWC also talked about the potential competitive disadvantages that the proposal creates, in part because it does not contain the EU’s exemption for calculating CVA on non-financial user and pension fund exposures.

Tom Deas of the National Association of Corporate Treasurers similarly raised concerns about the lack of an end user exemption from the CVA requirement for unmargined derivatives trades, and how the resulting increase in the cost of hedging would put non-financial American companies at a competitive disadvantage versus their peers in other jurisdictions.

Peter Ryan: So, extrapolating from this discussion, it seems that the participants were recommending that the agencies follow the lead of other major regulators and exclude client-cleared derivatives from the CVA’s scope, with some participants also favoring an end-user exemption for unmargined derivatives trades. And as SIFMA has suggested in other contexts, risk weights should also be adjusted to reflect the different levels of regulation that a bank’s financial counterparties are subject to.

Moving onto another topic: securitizations. What did the participants have to say about the proposal’s effect on the markets for asset-backed securities? Did they suggest any potential solutions to mitigate potential negative impacts?

Joe Seidel: As David Lefkowitz from JP Morgan noted, this is a critically important issue because, as currently proposed, the rules will have a direct impact on the cost consumers pay for mortgage, auto, and other credit as well as the cost many US corporations pay for credit. As David observed, the proposed changes would lead to:

David Lefkowitz: Higher capital requirements for banks for the same risk they hold today, in some cases, two to three times or more, and asset-backed securities and mortgage-backed securities can be multiples of this, which will lead to increased cost for funding and ultimately to increase costs for the rates that US consumers pay. To put it simply, if an auto lender can finance their loans at treasuries plus 150 today, but in a future state, it costs that same auto lender treasuries plus 300 for financing, it follows that the cost of that auto loan to the consumer will have to increase. The Basel III Endgame rules for securitization as currently proposed will lead to this outcome, increasing the cost of credit and potentially decreasing the availability of credit to US consumers and businesses.

Joe Seidel: SIFMA has proposed changes to the framework for securitizations that would avoid these undue negative impacts, including changes that David discussed, such as a reduction in the proposed “p-factor” capital add-on that is applied to banks’ securitization exposures.

Peter Ryan: Those are obviously incredibly important impacts that would affect practically every consumer and business in this country. The Roundtable participants addressed a couple of other key topics during their discussion, including the minimum haircut framework for Securities Financing Transactions (SFTs). Joe, why does this framework matter, and what changes should be made to the proposal?

Joe Seidel: The SFT minimum haircut framework was included as part of the Basel framework. In short, it would apply a haircut floor to certain SFT transactions with “unregulated” financial institutions, primarily as a mechanism to prevent the buildup of leverage in the hedge fund sector. However, the vague description of “unregulated” financial institution would result in an overly broad scoping that would lead to pension funds, mutual funds, and insurance companies being treated in the same way as hedge funds.

As Adam Gilbert noted, the proposed framework is also incredibly complex from both an operational and governance perspective, which is why PWC found that there would be a significant reduction in US SFT financing transactions if this framework were to be implemented. This would be a very concerning outcome, given that SFT markets, such as the repo markets, are crucial to the functioning of the broader financial system. In addition, these types of transactions serve as an important source of income for securities lenders such as pension funds and insurers, so a smaller securities lending market will ultimately flow through to lower returns for retirees and potentially higher insurance premiums for businesses and consumers.

For all of these reasons, no other major jurisdiction has implemented this portion of the Basel proposal. SIFMA has recommended that the U.S. should follow suit and drop this framework from the final rule.

Peter Ryan: That’s an incredibly important point. One other thing I’d highlight from the Roundtable was the discussion around the proposed operational risk capital changes, particularly the adverse treatment of low-risk capital markets fee-based services such as client clearing, custody, retail brokerage, and investment advisory services. As Adam Gilbert, echoing other comments during the Roundtable, noted:

Adam Gilbert: The structure of the operational risk RWA requirements penalizes firms with fee-based businesses that are often lower risk. That’s been mentioned before, which runs counter to the goal of having more risk sensitive capital requirements.

Peter Ryan: This is in large part because the service component of the new operational risk framework does not have a cap or an offset of expenses to fees. And as was noted during the Roundtable, these effects on lower risk, fee-based businesses are compounded by the proposal’s calibration of the so-called “Internal Loss Multiplier” or ILM, which was much more punitive than the approach taken in the EU or UK, as well as the overlap with the Fed’s stress tests that we talked about earlier.

This treatment would increase the costs of these fee-based services for retail customers and others, and/or cause banks to pull back from providing them altogether, with no guarantee that others will fill those voids. It also runs counter to the past 3+ decades of US financial services policy, which has sensibly encouraged banks to diversify into these low-risk fee-based business lines.

SIFMA and others have put out a series of recommendations for significant revisions to the proposed framework that would better incentivize sound risk management practices and diversified business models, which we hope the agencies will adopt.

Joe Seidel: Thanks Peter – all very good points. That brings us to the end of our discussion today. For a deeper dive on the topics we covered today, we recommend you watch the full SIFMA Basel III Endgame Roundtable, check out SIFMA’s blog series on the Basel Endgame, and watch some of our short explainer videos on Basel-related issues. Thanks for listening, and thanks Peter for joining me today.

Joseph Seidel is Chief Operating Officer of SIFMA. 

Peter Ryan is Managing Director and Head of International Capital Markets and Strategic Initiatives, SIFMA.