House Committee on Financial Services: Rules Without Analysis: Federal Banking Proposals Under the Biden Administration

House Committee on Financial Services

Subcommittee on Financial Institutions and Monetary Policy

Rules Without Analysis: Federal Banking Proposals Under the Biden Administration

Wednesday, January 31, 2024

Topline

Republicans voiced concerns that the proposals are overbearing and unnecessary, and that the Basel III endgame will hurt US markets and consumers domestically and internationally.
Democrats showed mixed support for Basel III endgame while criticizing pieces of the rule they found problematic.

Witnesses

Mr. Greg Baer, President & CEO, Bank Policy Institute
Mr. Bryan Bashur, Director of Financial Policy, Americans for Tax Reform
Mr. Randall Guynn, Chair, Financial Institutions, Davis Polk
Professor Jeremy Kress, Assistant Professor of Business Law, Stephen M. Ross School of Business, University of Michigan

Opening Statements

Subcommittee Chairman Andy Barr (R-Ky.)

In his opening statement, Barr said that after asking regulators multiple times, Congress has not seen any analysis of why the existing bank capital framework needs to be overhauled, or how the numerous regulatory proposals over the past year will work. He said that rules without analysis, such as the Basel III endgame, lead to bad policy outcomes and invite mistakes that will later result in unintended consequences and that the failure to properly analyze proposed rules and follow administrative procedures represents an abdication of responsibility on the part of regulators who have made numerous significant and under analyzed new regulatory proposals.

He expressed his disapproval of Basel III by saying it involved trillions of dollars of resource allocations and will increase regulatory costs for about $22 trillion in assets, which he noted is 80% of all US banking assets. Barr recognized that Basel III endgame had comments submitted from wide range of interests and from across the ideological spectrum. He noted that these comments also expressed far-reaching and widespread concerns, and he showed concern that the Basel III endgame proposal will reduce credit availability and increase costs for consumers, homebuyers, businesses, and small manufacturers and will ultimately make US institutions less competitive globally. He then said that the proposals have nothing to do with the bank failures that occurred in March of 2023. He closed by saying the bottom line is that the Basel III endgame proposal contains fatal flaws across the board, and we know nothing about how it would holistically interact with the numerous other significant recent and prospective regulatory proposals.

Subcommittee Ranking Member Bill Foster (D-Ill.)

In his opening statement, Foster said the Basel III endgame proposals from federal banking regulators aim to bolster the safety and soundness of the US banking system by ensuring that US banks properly manage and internalize the risk they take on. Foster talked about the 2008 financial crisis and how the resulting bank bail outs cost US taxpayers close to half of a trillion dollars. He said that under Basel III, capital requirements can increase the cost of capital for these large banks which will, to some extent, increase the cost of loans and potentially create economic incentives. Foster reminded committee members that during the lead up to Dodd-Frank, banks thought that it would ruin them but after Dodd-Frank was enacted, US banks continued to earn record profits and increase their market share around the world. He closed by noting that he had been mainly focusing on trying to understand how banks will change their business in response to these changes in capital requirements and expressed that that’s where he will continue his focus.

Testimony

Greg Baer, President & CEO, Bank Policy Institute

In his testimony, Baer warned that if adopted, the capital rules proposed by the federal banking agencies would have a profound effect on the cost of credit for nearly every American business and consumer, as well as on the resilience of US capital markets. He said the current proposal adopted the risk weights negotiated by agency staff and the Basel committee over six years ago and then added arbitrary surcharges. He explained that the proposal fails to completely acknowledge that in the US and the US alone, the Fed has already imposed a stress capital surcharge for most of the same risks. He questioned the purpose of Basel III and said that there is nothing about the real-world performance of US banks to suggest that their trading operations are critically undercapitalized, and the proposed rule makes no attempt to show that either. Baer closed by urging the agencies to withdraw the proposal, draft a new one, show their work, and open it up for public comment.

Bryan Bashur, Director of Financial Policy, Americans for Tax Reform

In his testimony, Bashur stressed that Basel III endgame would force large banks to build up more capital through retained earnings and additional stock issuances without any input from Congress. He continued by noting that the new proposed rules will make borrowing more expensive, hamper dividends, and reduce the availability of credit cards and mortgage loans, activities, and services. Bashur recommended that banks remain private and are not regulated to such an extent that they resemble heavily regulated utilities or other quasi-governmental entities. He closed by saying the proposal also largely eliminates the use of banks’ internal models without any empirical analysis and described Basel III as arbitrary, capricious, and abusive.

Randall Guynn, Chair, Financial Institutions, Davis Polk

In his testimony, Guynn said the proposed regulations would act similar to an excise tax that would increase the cost and decrease the supply of credit to businesses and families and that the proposals would fall most heavily on the regional banks. He warned that Basel III will increase the cost and reduce the supply of market making, which in turn will make markets become less liquid, and it will become more expensive for businesses and local governments to raise debt and equity capital. Guynn also warned that Basel III endgame would subject US banks to significantly higher capital requirements than banks in the UK, Europe, and Asia, and that even if the US proposal were capital neutral, US banks would be subject to higher capital requirements than their foreign competitors. He closed by noting the opposition to the US proposal and said he can’t recall another proposal that received so much dissent and negative comments from such a diverse cross-section of the public.

Jeremy Kress, Assistant Professor of Business Law, Stephen M. Ross School of Business, University of Michigan

In his testimony, Kress said these rules will better calibrate large banks’ capital requirements to the risk these banks pose to society and reduce the likelihood of financial crises that could devastate the economy. He recognized that higher capital is essential to making the US banking system safer and more efficient and that stronger capital requirements will help reduce the need for extraordinary interventions in the future. He praised Basel III endgame and said that the endgame rules will foster, not threaten, credit availability as most of the proposed capital increase is associated with large banks, trading, and fee generating businesses. He rebutted other panelists’ arguments by noting that requiring banks to fund themselves with more equity will not impair credit availability, but it will modestly reduce bank stock prices, shares, buybacks, and executive compensation. Kress also said that the level of analysis in the current proposals is at least equal to, and in many cases exceeds, prior federal banking agency rules.

Question & Answer

Credit, Mortgages, & Loans

Rep. Bill Posey (R-Fla.) asked panelists what their research and experience suggests when it comes to mortgages and small business loans under these new capital rules. Baer said under Basel, as proposed and agreed to in 2017, the risk weight is 25%. He continued that under these proposals, some risk weights will be increased by 3-, 4-, or 5-times current rates. Guynn added that the high increase in capital requirements for market risk will increase the cost and reduce the supply, which will ultimately make markets less liquid and more expensive for local governments to finance their infrastructure. Bashur noted that he is very concerned about credit cards and the expansion of the supplementary leverage ratio because credit cards will be considered an off-balance sheet exposure.

Rep. David Scott (D-Ga.) asked Kress if he has seen an openness by regulators to make some adjustments in the proposal with respect to how loan-to-value (LTV) residential mortgages are treated. Kress said he thinks it’s a great example of the public notice and comment process working as intended, and that the agencies have heard a lot of feedback on the residential mortgage front and have indicated that they will take that into account.

Scott then asked what the impact of risk weights would be for mortgage loans if they are compounded with the operational risk charge and the Federal Reserve stress tests. Baer said there are many things within the nooks and crannies of this proposal whose effect would be profound, adding that people can expect the trend of the market share of banks in mortgage to continue to decline.

Rep. John Rose (R-Tenn.) asked if the disproportionate and unfounded capital constraints created by the Basel proposal further restrict access to credit, increase consumer credit prices, and exacerbate inflationary impacts for working Americans. Guynn agreed and said that basic economic analysis shows that the increased capital requirements will increase costs and decrease benefits and noted that the regulators have not put forth any evidence that these massive capital increases are necessary.

Rep. Roger Williams (R-Texas) expressed his concerns that the banking agencies are rolling out proposals like Basel III endgame in a rushed fashion without considering how these combined regulations and requirements might impact innovation, limit access to capital, and threaten economic stability. Williams then asked if these rules were analyzed collectively. Baer said they were not analyzed individually or collectively.

Rep. Ralph Norman (R-S.C.) asked if Basel III is going to negatively affect the housing market. Baer agreed saying that the analysis needs to be done asset-by-asset and the rule would actually help the commercial real estate market. Bashur added that regarding mortgages, the new risk weight is arbitrary.

Rep. Sean Casten (D-IL) expressed concerns about the different risk weighting for things that are comparable. Particularly about tax equity provisions where if you are using tax equity for new market housing, there is one level of risk, and if you are using it for new energy investing, it has four times the risk. He then asked if this would reduce or eliminate the ability of banks to invest in renewable energy projects. Baer said it would.

Rep. Gregory Meeks (D-NY) asked Baer how the various regulatory proposals could interact and how consumers would be affected. Baer said this is a prime concern and explained that in the Basel proposal the overlay between operational risk and credit risk has not been considered. He also noted that the securitization aspect of the proposal has punitive charges that would affect the ability to make mortgage loans, auto loans, credit card loans, and effectively distribute that risk.

Market Risk & Capital Requirements

Barr asked Baer to clarify the treatment of market risk in the Basel III proposal and the likely impacts. Baer said market risk is a complicated subject as it’s very difficult to measure, but it can be and is measured in the proposal. He clarified that the problem with Basel III endgame is that market risk is covered twice, through the Fundamental Review of the Trading Book (FRTB) and Fed stress tests.

Barr then asked if there is a worry that the abandonment of internal models will cause risk profiles to be homogenized and thereby threaten financial stability. Baer said that in the US, the largest banks use what is called the “advanced approach” which is a granular model, while standardized models lump together classes of loans that do not have a lot in common. He explained that the current method has been operating since 2011 under stringent guidance from the agencies who have at no point raised any concerns about accuracy. He finished by saying that under Basel III endgame, the use of models is permitted; however, only in the US are they proposing to eliminate the use of models which will certainly herd banks into the asset classes that are favored by the standardized model.

Foster asked all panelists if US banks will no longer be competitive and continue to increase their market share under the Basel III endgame proposal. All panelists said US banks would continue to be competitive; Baer said it would be business line specific but in the aggregate the US would remain competitive.

Foster then asked Baer and Kress about double counting under stress conditions for banks and how many banks would fail under the worst-case geopolitical situations. Baer said Basel III endgame is going to ensure that regulators can look at all the types of securities, how much liquidity there is going to be, and how long the institution will be able to sell that security for. He continued, saying that the conditions are agnostic to cause, they are calibrated around the financial crisis, and it is hard to imagine that we see something of that magnitude. Kress recalled the bank failures of 2023 and recommended that there needs to be more variety in stress test scenarios and that capital requirements and the stress tests do two separate things.

Williams asked Baer to elaborate on the competitive disadvantages that US banks, businesses, and consumers will face due to this proposal. Baer said that this will depend on the business line and the biggest impact would be in financial markets and capital markets where US banks have done terrifically well.

Rep. Maxine Waters (D-Calif.) asked Kress if the proposal would help fix the problems like what we saw with SVB being exempt from certain bank capital requirements pursuant to a Trump regulatory rollback. Kress agreed and said that the Trump administration rolled back bank regulations and SVB showed that this kind of deregulation creates problems.

Waters then asked Kress that with the federal bank regulators jointly issuing a proposal to strengthen capital requirements for the biggest banks, if members of Congress should be supporting Basel III endgame to avoid another catastrophe, such as the failure of SVB. Kress agreed again. Waters closed by saying that Basel III will help prevent future financial crises.

Rep. Byron Donalds (R-Fla.) asked Guynn if he is aware of any study that has shown a causal connection between US banks’ capitalization and their global competitiveness. Guynn said he was unaware. He then asked Guynn if US banks are competitive as compared to other ways of raising capital, such as private equity, that don’t have to deal with Basel requirements or the burden of the regulatory system in the US. Guynn agreed and said one of the consequences of the proposal will be to continue the trend of non-bank institutions having a greater share of the credit provided in the US economy.

Rep. Al Green (D-Texas) asked Kress if Basel III endgame would benefit banks and allow them to lend more. Kress agreed and said that strong capital rules force banks to internalize costs, weak capital rules force them to externalize costs.

Posey cited the Secretary of the Treasury, Janet Yellen, as saying after the failure of Silicon Valley Bank (“SVB”) that the banking system is well capitalized and asked the witnesses whether this is true. Bashur and Baer said that they agreed. Kress said they are well capitalized under the legal definition (10% equity) but that is different than the normative question of whether they are actually well capitalized enough for us to be comfortable with the activities that they are engaging in. Guynn said that none of the agencies have put forth any evidence that they are not sufficiently capitalized and that recent history, such as the Covid-19 pandemic, has shown that they are well capitalized.

Small Businesses, Regional Banks, & Farms

Rep. Brad Sherman (D-Calif.) said Basel III endgame proposal does nothing to learn from the SVB failure, and encourages banks to engage in risky and profitable bets on long-term, non-interest rate adjustable bonds if they want to make profit, and hurts first-time homebuyers, people of color, and small businesses. Sherman said that these proposals go beyond just being in harmony with Europe and that one area that they are inadequate in is interest rate risk. Sherman said that this proposal advantages big businesses.

Rep. Blaine Luetkemeyer (R-MO) agreed with Sherman on the effects of Basel III and the fact that it does nothing to address the SVB failure. Luetkemeyer then said that the problem with SVB was not that it was undercapitalized but that they were under regulated, and their business model was allowed to go unchecked. He said that he thinks that this is the regulators trying to “cover their rear end.”

Rose said that the Basel III endgame proposal is flawed and will have harmful impacts on consumers, agriculture, and small businesses. Bashur agreed and noted particularly that it will affect derivatives which are very important for agricultural producers who use them to hedge risks.

Green asked Kress if any community bank in the US would be impacted by Basel III. Kress said no community bank would be impacted and that only 37 large banks would be subject to the proposal. Green cited the times that the government has bailed out large banks and said that he does not want to see that anymore. Kress agreed and said that over the past 15 years, we have many times that the government acted as a backstop for banks.

Williams asked Bashur to expand on how the Basel III proposal will impact small businesses’ ability to grow and thrive in the economy. Bashur said it will have a detrimental impact on small businesses because of the retail exposure provision in this proposal.

Rep. Joyce Beatty (D-Ohio) asked if the Basel III proposal decreased risk weights for all small businesses or just a subset. Kress said it depends based on if the company is publicly traded or non-publicly traded. He added that for small businesses, the risk weight is 100%, which is the same as the risk weight under the existing capital rules.

Beatty then asked Kress what the reasoning was behind the different risk weights for these types of businesses, and what changes can we make in the final rule to achieve the same goal without disadvantaging small businesses. Kress said federal regulators indicated an openness to considering alternatives.

Rep. Scott Fitzgerald (R-Pa.) asked if during a time when small businesses are facing tighter monetary policies, particularly when it comes to securing loans from non-traditional lenders, if revising bank capital standards under Basel III endgame would further limit small business credit. Baer agreed and added that regarding the risk weight on publicly traded vs. non-publicly traded companies, banks’ internal business risk analysis shows their trading status does not increase the risk.

Rep. Young Kim (R-Calif.) expressed her concerns that the Basel III endgame and other proposals will make credit more expensive for small businesses. Kim asked Guynn if the proposal would push banks to consolidate and how greater consolidation of banks will impact credit for small businesses and households. Guynn said the reason there’s a disproportionate impact on the regional banks is because they would be subject to capital requirement increases and would now be subject to the subordinated long-term debt requirement. He then explained banks would be pressured to consolidate because these dramatically increased requirements will incentivize banks to become larger to spread new costs over a larger scale.

Rep. Monica De La Cruz (R-Texas) asked if regulators have provided an analysis on the impact Basel III will have on regional bank customers and the farming and ranching communities. Baer said they have not. De La Cruz added that she worries about the impact on rural communities.

Rep. Barry Loudermilk (R-Ga.) asked about the impact of Basel III on smaller banks. Guynn said that while it is currently only applicable to globally systemically important banks (“G-SIBs”), there is a risk that it will be applied downwards. He also noted that there is a cliff-effect, banks may not want to cross the $100 billion threshold even if market forces are pushing them towards crossing it.

Administrative Procedure and Economic Analysis

Barr asked how important it is for the Federal Reserve to give the public and regulated institutions sufficient time to comment on the rule’s quantitative impact study. Guynn said that this is important and said that one of the surprises here is that they did not do the quantitative impact study at the same time that they released the rule. He said that people need 60-90 days to actually absorb that kind of study and comment on it appropriately. Barr finished his time by saying that it is possible to cure disease by killing the patient but that he does not think that we should kill the patient.

Luetkemeyer asked Baer what problem this rule is trying to solve. Baer responded that he thinks that at the genesis of it in 2017, global regulators agreed to Basel and now they are getting around to implementing it. He explained that the US proposal is not what was agreed to and that US regulators have added to it beyond what the other countries are doing. He says that he understands the spirit but what they are implementing is not Basel.

Loudermilk said that there are a lot of problems with Basel III and asked if there would be appropriate to withdraw it and reintroduce it. Baer said that this would be appropriate and necessary because it is necessary to do the cost-benefit analysis that did not happen when the rule was first proposed.

Casten asked Kress if there was a discussion while he was at the Fed drafting some of the early Basel rules about how a potential rule would affect clean energy markets and tax credits. Kress replied saying that this is a perfectly normal part of the notice and comment process, and that feedback would be considered in a final rule in line with the APA. He also noted that the tax equity piece of the proposal is a very small part of the Basel package and if changed, it would not materially weaken the overall goal of the proposal.

Meeks noted that he has found a willingness among prudential regulators to address his concerns and noted the way the proposal treats high loan-to-value (LTV) mortgages is a concern for low- and middle-income, as well as minority households. He then asked Kress if he believes the current proposal will translate to higher costs for the highest LTV mortgages and if he could identify targeted changes to address this. Kress noted that in the proposal the regulators laid out three possibilities for how to change risk weights for residential mortgages. He continued saying that he knows the regulators have received comments on each alternative and are open to changing those options.

Rep. Andy Ogles (R-Tenn.) asked if the proposal should be withdrawn due to a lack of analysis done. Baer said that parts of it should certainly be and said at that point they should withdraw the entire proposal. He also noted that it is not just banks submitting comments, citing civil rights groups, community groups, end-users, and other industries who have submitted comment letters with their issues with the proposal. Bashur added that given the lack of economic analysis and the fact that the rule is an abuse of the regulators’ authority, the rule should be withdrawn.

Ogles then mentioned a comment letter signed by Baer’s organization and other others that noted that there were significant violations of the APA when it comes to the proposal. He asked Baer to touch on what violations there were and then asked more broadly why the US would want to comply with foreign ideas from Europe, Russia, and China on capital requirements when we have a completely different system. Baer said he does think that there is virtue to having conformity with other countries we do business with and said the irony is that if the proposal was more similar to what Europe and the UK proposed, many people would not have as many problems with the proposal.

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