New ‘endgame’ bank rules promise greater financial stability, lower returns

The banking sector is bracing for a major set of regulations prompted by the 2007-08 financial crisis, but which has origins extending as far back as the termination of the gold standard and the introduction of freely floating international currencies.

Bank regulators around the world are poised to finalize the third Basel Accord, an international set of bank capital rules born from a summit that began in 1974.

Experts say the new regulations, known as the “Basel III Endgame,” are still necessary and will help to stabilize an international financial system that is prone to periodic collapse.

Meanwhile, banking industry groups and lobbies are firing on all cylinders to water down the proposed rule changes ahead of a January 16 deadline for public comment.

The new international rules compel banks to hold more capital and rely less on their internal modeling. While the risk of traditional bank runs like the ones that brought down Silicon Valley Bank (SVB) and Signature Bank earlier this year likely won’t be substantially mitigated by Basel III Endgame, experts say it could reduce the risk of a deeper, industry-wide failure like in 2008.

“There’s a vast body of academic research that presents … a very broad consensus to say that from the current level an increase in capital requirements is probably a good idea – that’s viewed from the perspective of the system as a whole, not from that of an individual bank,” Nicolas Véron, a senior fellow with the Peterson Institute for International Economics, told The Hill.

What will Basel III mean for banks?

The central feature of the new banking rules is higher requirements for capital, which is a measure of the resources banks have to withstand losses. The Federal Deposit Insurance Corporation (FDIC) estimates an aggregate 16-percent increase in common equity requirements for affected banks.

The rules would also broaden out these requirements for banks worth $100 billion or more, pulling the threshold for more capital down from the $250 billion mark to apply to banks of the size of SVB and Signature.

Banks and their advocates tend to oppose increasing capital requirements, arguing that the Dodd-Frank reforms following the 2007-08 crisis were sufficient and stricter rules will mean fewer loans into the economy.

Higher capital requirements also limit banks’ ability to leverage their capital and extend their balance sheets with borrowed money to distribute more profits to shareholders.

But the Bank of International Settlements (BIS), the international coordinating body for central banks like the Federal Reserve, says that too much leverage was a driving force behind the 2007-2008 financial crisis.

“An underlying cause of the global financial crisis was the build-up of excessive on- and off-balance sheet leverage in the banking system,” a BIS write-up of the Basel plan reads.

“At the height of the crisis, financial markets forced the banking sector to reduce its leverage in a manner that amplified downward pressures on asset prices. This deleveraging process exacerbated the feedback loop between losses, falling bank capital and contracting credit availability.”

More transparency on leverage ratios

Having banks use a more standardized risk model is another key feature of the new rules. The last round of Basel regulations allowed banks to do their own risk assessments.

“This was a very easy system to game,” financial writer and researcher Nathan Tankus told The Hill in an interview. 

“You would have a risk modeler who would come in from the compliance department, model the activities that a trading desk was doing, let them do that for a few weeks. Then you would kick the compliance person out, make sure they weren’t allowed at your desk anymore, and then you’d play around with the model and figure out what risk you can take to earn more money without the risk model realizing it,” he said.

The BIS has also called out this operational duplicity and suggested it needs to be amended.

“In many cases, banks built up excessive leverage while reporting strong risk-based capital ratios,” the BIS wrote in 2017.

The proposed rule changes include replacing banking organizations’ internal models for credit risk and operational risk with standardized approaches, the Federal Reserve says.

Disputed effects of higher capital requirements

Bankers say that having to keep more capital on their books means they will decrease lending to households and small businesses or increase the interest rates on their loans, making them more expensive.

“When capital requirements are set excessively high, it makes it much harder to secure a loan or credit — this is especially true for working families and small businesses,” the Bank Policy Institute, a trade group for the banking industry, says on its website.

“If we go too far in terms of burdening US banks with regulations, it is absolutely going to negatively impact a specific subset of people that rely on those institutions, not only for business loans but personal loans, agricultural loans, that type of thing,” financial services director Dana Twomey of consultancy West Monroe told The Hill.

But some research says otherwise.

One frequently cited paper from 2009 found “that there would likely be relatively small changes in loan volumes by U.S. banks as a result of higher capital requirements on loans retained on the banks’ balance sheets.”

Even if banks restructure their balance sheets to optimize returns on stock, such moves “appear unlikely to be large enough, even in the aggregate, to significantly discourage customers from borrowing or move them to other credit suppliers in a major way,” the researcher found.

Another BIS paper found that “loss-absorbing capital is only a small proportion of banks’ balance sheets. Increasing this proportion to 10 to 15 percent does not materially affect a bank’s average cost of funding.” 

Even assuming diminished lending as a result of higher capital requirements, the Fed could very well offset this stinginess with lower inter-bank interest rates, which could have a more broadly stimulative effect on the economy even despite tighter private lending standards.

“A bug here can also be seen as a feature,” Tankus told The Hill.

What are lawmakers saying?

Some Democrats have been trumpeting the new rules, arguing they’re needed to stabilize the economy against the next inevitable crisis.

“The Fed’s rules for stronger capital requirements for big banks are crucial to protect the economy and taxpayers when banks take risky bets and lose money,” Sen. Elizabeth Warren (D-Mass.) said in a statement to The Hill. 

“Wall Street executives are fighting tooth and nail against these rules because they threaten their multimillion-dollar bonuses — but regulators must reject the Big Bank lobby’s efforts and finalize strong capital requirements swiftly,” she said.

Key Republicans on the Senate Banking Committee and House Financial Services Committee have largely backed the banking industry.

“This proposal could limit, and frankly I think will limit, the following: availability of credit for housing for those who need it most, severely restrict lending for small businesses,” Sen. Tim  Scott (R-S.C.) said during a hearing on Wall Street oversight earlier this month.

In a letter to financial regulators sent in September, House Republicans bemoaned the increased capital requirements and said the whole plan should be scrapped.

“The proposal .. would force the U.S. to overcapitalize financial institutions, compromising our global competitiveness,” they said.

Just how stable is the financial sector now?

The financial sector teetered in March after SVB and Signature tanked due to clumsy management and basic interest rate exposure — something regulators could have caught but didn’t. 

This resulted in the Fed’s extending a line of credit backed by taxpayer money to the banking industry, as well as a private-sector bailout from other big banks to rescue First Republic, another lender that was about to go under.

“The failure of two regional banks in Spring 2023 underscored that activities of non-global systemically important banks can pose a risk to financial stability,” the Treasury Department’s Financial Stability Oversight Council (FSOC) said in its annual report, released last week.

Despite fears of wider failures on the scale of 2007, governmental and private-sector bailouts were able to prop up the industry, further buttressed by the roaring post-pandemic recovery, leading FSOC to deem the U.S. banking system in December “resilient overall.”

But some substantial risks for FSOC remain, notably in securities related to residential real estate and the $6-trillion commercial real estate sector. They’re risks that raise the specter of the predatory securitized mortgages that tanked big banks starting in 2007 and led to a legislative rescue of the industry.

Maturing loans and expiring leases amid weak demand for office space have the potential to strain the sector further, Treasury officials told The Hill, encouraging market participants to keep a close eye on the sector.

Failures there could spread beyond that segment of the market, they said.

Despite the warnings, the financial sector doesn’t want any more interference in how they securitize mortgages or other types of loans.

“Capital requirements play a key role in the ability of banks to participate in securitizations to fund lending. Higher capital requirements would force banks to hold less inventory leading to lower [asset-backed security] liquidity and higher spreads which in turn raises costs for consumers and businesses,” financial trade group SIFMA said in a November statement.

Market commentators say that changing the way securitization markets work and reining them in is precisely the point of the new regulations.

“Whatever you think about the [impact of these rules on securitization] and how true that is, there’s a certain point of view that says ‘Well, good. That’s a feature, not a bug. Securitization has all sorts of potential pathologies … and so much the better for our financial markets,” Tankus told The Hill.