Understanding the Current Regulatory Capital Requirements Applicable to US Banks

Part I in Our Series on US Bank Capital Requirements

In this, the first of a series of blogs on prudential requirements and their impacts, we discuss revisions to bank capital requirements to increase both the quality of capital and the quantum of capital in the system that occurred in the wake of the Great Financial Crisis.
As we describe in this blog, these reforms have led to U.S. bank capital levels that are now extraordinarily robust relative to their pre-crisis levels.
While this has undoubtedly made the banking system safer, it also comes with costs to the real economy and capital markets, including on retail investors and end users such as corporates.
Policymakers must weigh these costs against the benefits of yet further reforms envisioned to the capital framework as part of the so-called “Basel III Endgame” framework. We will discuss the Basel Endgame framework and its impacts in more detail in future blogs.

Background

In response to the 2008-09 Great Financial Crisis, the Basel Committee on Banking Supervision (BCBS), as well as national authorities, instituted a series of wholesale reforms to the pre-crisis prudential regulatory framework. The revisions put in place:

heightened capital requirements;
new minimum liquidity requirements;
new margin requirements;
stress testing requirements;
single counterparty credit exposure limits;
strict limits on proprietary trading;
mandated greater use of central clearing;
created new mechanisms to ensure orderly resolution of financial firms, such as Total Loss Absorbing Capacity (TLAC) capital and resolution planning requirements;
and generally led to enhanced on-going supervision of large banks.

All these measures were designed to work in tandem to dramatically reduce the likelihood of a major bank failing, as well as limit cross-institutional contagion that could result in another banking crisis. As a result of this enhanced prudential framework, all domestic and internationally active banks came out the deep market downturn induced by the COVID-19 pandemic unscathed.

In this, the first of a series of blogs on prudential requirements and their impacts, we discuss what is often seen to be the most important element of these post-crisis reforms: revisions to bank capital requirements to increase both the quality of capital and the quantum of capital in the system. We note that as a result, U.S. bank capital levels are now extraordinarily robust relative to their pre-crisis levels. While this has undoubtedly made the banking system safer, it also comes with costs to the real economy and capital markets. Policymakers must weigh these costs against the benefits of yet further reforms envisioned to the capital framework as a result of the “Basel III Endgame” (hereafter referred to as the “Basel Endgame” framework), which will be the subject of a proposed rulemaking by the U.S. banking agencies this year (and will be the subject of future blogs).

The BCBS began a process to comprehensively revise global bank capital standards in 2010. The objectives of these revisions were first to increase the quantum of capital in the banking system and second to decrease variation between banks in the way risk-based capital charges were calculated (and thereby facilitate better supervisory oversight on banks’ risk measurement and management). The first set of revisions, commonly referred to as “Basel III,” were finalized by the BCBS in 2011 and were aimed at addressing capital quality and inadequacy resulted from the framework in place pre-crisis.^[1] The Basel III framework was implemented in the U.S. in 2013 and is described in greater detail in this blog. The goal of the second set of reforms package, “Basel Endgame”, was to reduce the excessive variability across capital requirements and was finalized by the BCBS in 2017.^[2] The European Union and the United Kingdom, among other jurisdictions, have published proposed rules seeking to implement the Basel Endgame framework. The U.S. Notice of Proposed Rulemaking (NPR) implementing the Basel Endgame framework is expected to be released in the coming months.

Current U.S. Capital Requirements: A Brief Primer

Current U.S. regulatory capital rules subject large banks to risk-based capital (RBC) requirements, leverage capital requirements (including U.S. leverage ratio and supplementary leverage ratio or SLR), and additional capital buffers including the Stress Capital Buffer (SCB) for banks subject to the Federal Reserve Board’s Comprehensive Capital Analysis and Review (CCAR) requirements, capital conservation buffer (CCB) for banks not subject to CCAR requirements, and the Countercyclical Capital Buffer (CCyB)^[3] . The SCB is a U.S. specific regulatory capital add-on to the minimum capital requirements set out by the Basel standards and is the result of integrating CCAR requirements into the regulatory capital rules. In theory, a bank that does not maintain capital ratios above its minimums plus its buffer requirements faces restrictions on its capital distributions and discretionary bonus payments. But in practice, due to the punitiveness of the restrictions and market perception, the buffers requirements are de facto minimum requirements.

For purpose of risk-based capital requirements, the current capital rules provide two approaches for calculating risk-weighted assets (i.e., the denominator of the RBC ratios) – the “Advanced Approaches” and the “Standardized Approach”.

In addition, U.S. global systemically important banks (GSIBs) are also subject to GSIB surcharge which is computed using a U.S.-specific method that generally results in a higher GSIB surcharge than the BCBS internationally agreed method. U.S. GSIBs are also subject an SLR buffer – the enhanced SLR requirements (eSLR), and total loss-absorbing capacity (TLAC) requirements. The current capital rules group banks into five risk-based tiers (or categories) based on a set of risk-based indicators.^[4],^[5] The eight U.S. GSIBs occupy the first tier (or Category I) and gradually less systemically important banks populating the remaining 4 categories as shown in Table 1. Applicable regulatory capital requirements are tailored to each category with the most stringent requirements applied to Category I banks (see Table 1).

Minimum Capital Requirements Under the Current U.S. Regulatory Capital Rules

As depicted in Figure 1, under the current capital rules, the largest U.S. banks must calculate and comply with up to 19 capital ratios and buffers requirements altogether:^[7]

6 risk-based capital ratios (i.e., Common Equity Tier 1 or CET1 ratio, the tier 1 capital ratio, and total capital ratio; each calculated under both Advanced Approaches and Standardized Approach);
4 risk-based capital buffers (i.e., SCB, CCB, CCyB, and GSIB surcharge);
3 leverage-based ratios and buffers (i.e., U.S. tier 1 leverage ratio, SLR, and eSLR); and
6 TLAC ratios and buffers (i.e., the risk-based TLAC ratio, the TLAC buffer, the eligible long-term debt or LTD ratio, the leverage-based TLAC ratio, the leverage-based TLAC buffer, and eligible LTD leverage ratio).

Smaller banks are subject to fewer capital ratios and buffers requirements.

Figure 1. Minimum Risk-Based Capital, Liquidity and TLAC Requirements Under the Current U.S. Regulatory Capital Rules^[8]

Despite being part of larger global organization, the U.S. intermediate holding company (IHC) of foreign banks operating in the U.S. must also meet U.S capital standards. Foreign banking organizations (FBOs) U.S. IHCs are subject to U.S. risk-based capital requirements, different leverage capital requirements including the SLR, and additional capital buffers including the SCB and CCyB, depending on their risk-based tier. These capital charges are in addition to the capital standards that foreign banks are subject to within their home jurisdictions.

In addition to this vast array of different capital ratio requirements, there are also differences between banks that are subject to the Advanced Approaches versus those that only use the Standardized Approach to calculating risk-based capital. The Advanced Approaches permit the use of banks’ internal models, whereas the Standardized Approach generally disallow internal models. The use of internal models allows for more accurate capture of risks, with capital requirements that more closely correspond to a bank’s risk profile. However, they inherently also lead to greater variability in capital requirements between banks. Reducing this variability is the key objective of the Basel Endgame framework, a topic that we will cover in the follow-up blogpost.

Pursuant to the Collins Amendment of the Dodd-Frank Act,^[9] the so-called “Collins Floor”, Advanced Approaches banks (Cat. I and Cat. II banks) must calculate each of the different risk-based capital ratios under both the Advanced Approaches and the Standardized Approach and must use the lower of each capital ratio calculated under the two approaches to determine risk-based regulatory capital compliance.

U.S. Bank Capital Levels Are Extraordinarily Robust

Since the current capital rules took effect in 2013, U.S. banks have built-up robust capital adequacy (both in terms of overall levels and quality of capital) and have steadfastly increased their CET1 capital levels in particular. As shown in Figure 2, the average of large U.S. banks’ CET1 capital ratios and levels grew by 2.4 percentage points and in excess of 88%, respectively, since 2009.

Figure 2. Average CET1 Capital Ratios and Levels of All CCAR Firms Since 2009.

Source: SIFMA Research Quarterly.^[10]

Policymakers are in broad agreement that both the quantum and the quality of capital in the system have improved dramatically over the past decade. Federal Reserve Board Chairman Jerome Powell observed in a February 2019 statement to U.S. House members noted that capital levels are “just right”.[11] Similarly, Acting Comptroller of the Currency Michael Hsu said, in May 2021, that banks’ “capital and liquidity ratios are strong”^[12] and he’s generally comfortable with big banks’ capital levels.^[13] As a result of these robust capital levels and along with the certain regulatory reforms from regulators, e.g., temporary exemption of U.S. Treasury securities and central bank reserves from SLR,^[14] the U.S. banking system weathered the COVID-19 event and its associated severe market stresses without any bank failures, while also continuing to support the capital market and the real economy.

The Cost of Bank Capital

“[B]ank capital is not costless to society. If capital requirements are increased, some of those costs will be passed on to households and businesses in the real economy”.^[15] Many studies have documented evidence of the costs associated with higher bank capital requirements. In the context of SCB, Cortes, et al (2022) show that banks subject to stress test requirements “reduce credit supply and raise interest rates on small business loans”.^[16] Higher bank capital requirement has real impacts on the economy and capital markets, including on retail investors and end users as well as in the form of reduced market liquidity and higher costs for both institutional and retail investors. Campbell (2023) provides an excellent literature survey which provides additional studies demonstrating the impact of higher capital.^[17]Additionally, there is some evidence suggesting that higher capital requirements (specifically leverage requirements) have constrained the ability of banks to provide liquidity to important funding markets such as the U.S. Treasury market, reducing liquidity and raising costs for investors.^[18]

Other studies attempt to identify the socially optimal bank capital level. We plan to survey this literature in future blogs. For example, when accounting for the interplay between capital and liquidity Begenau (2020) finds “the optimal capital requirement is 12.4% of risky assets.”^[19] Without counting additional capital, current common equity tier 1 capital alone at most banks already is around this optimal level as shown in Figure 2.

Conclusion

Currently, banks in the U.S. are subject to extraordinarily complex and stringent capital requirements, as discussed in this blog. All these measures were designed to work in tandem to dramatically reduce the likelihood of a major bank failing, and limit cross-institutional contagion that could result in another banking crisis. As a result, according to the Federal Reserve Board “the [U.S.] banking system remains strong”, and their capital and liquidity levels are “robust”.^[20] Unsurprisingly, all domestic and internationally active banks in the U.S. proved resilient throughout deep market downturn induced by the COVID-19 pandemic. But these higher capital requirements inevitably come at some cost to both the real economy and capital markets, including retail investors and end users such as non-financial corporates. Higher capital charges have implications for the for the availability and cost of credit to businesses. Policymakers should weigh these costs against the benefits before implementing the additional reforms envisioned by the Basel Endgame package – a topic we will focus on in a subsequent blog in this series.

Dr. Gouwei Zhang is Managing Director and Head of Capital Policy at SIFMA.

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

–

^[1] https://www.bis.org/publ/bcbs189.htm

^[2] https://www.bis.org/basel_framework/index.htm?m=2697

^[3] Note that the U.S. has not activated CCyB, but other jurisdictions have (e.g., Sweden).

^[4] The set of risk-based indictors is comprised of size, interconnectedness, cross-jurisdictional activity, substitutability, and complexity.

^[5] https://www.ecfr.gov/current/title-12/chapter-II/subchapter-A/part-252

^[6] The criteria for the categories are:

Category I, U.S. GSIBs;
Category II, ≥$700bn total assets or ≥$75bn in cross-jurisdictional activity;
Category III, ≥$250bn total assets or ≥$75bn in nonbank assets, wSTWF (weighted short-term wholesale funding), or off-balance sheet exposure;
Category IV, others banks with $100bn to $250bn total assets;
Other, $50bn to $100bn total assets

^[7] All Insured Depository Institutions (IDIs) are required to comply with Prompt Correction Action (PCA) which restricts or prohibits certain activities for all IDIs and establishes a framework of supervisory actions for IDIs that are not Adequately Capitalized. Under PCA, capitalization adequacy is assessed based on 4 capital ratios – 3 risk-based capital ratios and 1 U.S. tier 1 leverage ratio. https://www.federalreserve.gov/publications/2018-11-supervision-and-regulation-report-appendix-a.htm

^[8] Note that Internal TLAC and Eligible Long-Term Debt requirements also apply to certain Covered IHCs (that is IHCs controlled by a GSIB). Those requirements include a 16% RWA Internal TLAC + 2.5% TLAC Buffer + 6% Eligible Long-Term Debt minimum for Covered IHCs that operate under a single-point-of-entry (SPOE) resolution strategy. The equivalent numbers for Covered IHCs hat operate under a multiple-point-of-entry (MPOE) resolution strategy are 18% Internal TLAC + 2.5% Buffer + 6% Eligible Long-Term Debt. The TLAC SLR requirements applicable to Covered IHCs operating under a SPOE strategy are 6% TLAC + 2.5% Eligible Long-Term Debt. For Covered IHCs operating under a MPOE strategy, the requirements are 6.75% TLAC + 2.5% Eligible Long-Term Debt. Covered IHCs are also subject to TLAC U.S. Tier 1 Leverage Ratio requirements.

^[9] The Collins Amendment requires the appropriate Federal banking agencies to establish minimum leverage and risk-based capital requirements applicable to U.S. insured depository financial institutions will also extend to US bank holding companies, US intermediate holding companies of foreign banking organizations, and systemically important non-bank financial institutions.

^[10] “B3 Min” indicates the minimum required CET1 ratio applicable to all banks (i.e., 4.5% + 2.5% = 7%). “G-SIB Max” indicates the maximum required CET1 ratio applicable to all banks (i.e., 4.5% + 2.5% + 3.5% = 10.5%). Note that at the time of writing the highest actual G-SIB surcharge is 3.5%. https://www.sifma.org/wp-content/uploads/2022/03/US-Research-Quarterly-Financial-Institutions-2022-05-11-SIFMA.pdf

^[11] https://www.americanbanker.com/news/capital-levels-are-just-right-powell-tells-house-members

^[12] https://www.occ.gov/news-issuances/congressional-testimony/2021/ct-occ-2021-56-written.pdf

^[13] https://www.bloomberg.com/news/articles/2021-05-25/wall-street-watchdog-sees-little-need-to-ramp-up-bank-capital#xj4y7vzkg

^[14] https://www.federalregister.gov/documents/2020/04/14/2020-07345/temporary-exclusion-of-us-treasury-securities-and-deposits-at-federal-reserve-banks-from-the

^[15] https://www.parliament.uk/globalassets/documents/commons-committees/treasury/correspondence/mark-carney-governor-bank-of-england-to-rt-hon-andrew-tyrie-mp-5-04-16.pdf

^[16] https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3134262

^[17] https://fsforum.com/news/fixing-what-ain-t-broken-the-real-and-hidden-costs-of-excessive-bank-capital-regulation

^[18] For an overview, see Peter Ryan and Robert Toomey, “Improving Capacity and Resiliency in U.S. Treasury Markets: Part II,” March 30, 2021. Available at: Improving Capacity and Resiliency in US Treasury Markets: Part II – SIFMA – Improving Capacity and Resiliency in US Treasury Markets: Part II – SIFMA.

^[19] https://www.sciencedirect.com/science/article/abs/pii/S0304405X19302508

^[20] https://www.federalreserve.gov/publications/files/202205-supervision-and-regulation-report.pdf.