Part III in Our Series on US Bank Capital Requirements

• As we described in Part I of this series, the largest U.S. banks’ capital and liquidity levels have grown dramatically since the original Basel III standards were implemented in 2013 in response to the 2008 Global Financial Crisis (“GFC”). Today, as the Federal Reserve recently observed, the U.S. “banking system is sound and resilient, with strong capital and liquidity.”^[1]
• As we noted in Part II of this series, the soon-to-be-proposed Basel III Endgame represents a complete overhaul of the risk-based capital framework that was put in place in 2013, and it is expected to significantly increase banks’ capital levels, particularly on banks’ trading book activities as a result of the Fundamental Review of the Trading Book (“FRTB”) reforms.
• In this, the third in a series of blog posts on U.S. bank capital requirements, we discuss what the “optimal” level of bank capital should be – that is a level that provides a substantial margin of safety without impairing economic growth, lending, and capital markets activities.
• We highlight a recent PWC report that examines the post-GFC reforms to the prudential regulatory framework and surveys the academic literature on the benefits and costs of capital. That report finds that the capital levels for the largest U.S. banks’ are close to “optimal,” even before fully taking into account the extra financial stability benefits conferred by other non-capital requirements, such as enhanced liquidity and resolution requirements. This suggests that further significant increases in capital requirements will result in material costs for the U.S. capital markets and the broader economy.
• We also provide estimates of the impact of higher capital requirements on large banks’ trading book activities. We find that for every one percentage point increase in the effective risk weight of market risk capital, U.S. GSIBs’ aggregate trading assets/liabilities fall by $16.26bn. As a result, the expected FRTB effective RWA add-on risk weight of 8.36% would translate into a potential reduction in U.S. GSIBs’ aggregate trading assets/liabilities of roughly $136bn, had the FRTB been in effect as of December 31, 2022.
• Given that banks play a critical role in intermediating the U.S. capital markets and given that three-quarters of all non-financial corporate funding comes from those markets, the effect of these changes will thus likely be to increase the cost and decrease the availability of funding for businesses and consumers.

Introduction

As we noted in our prior blogs, the capital and liquidity levels for the largest U.S. banking institutions are strong and robust by historical standards and have proved resilient to a range of stresses in recent years. Nonetheless, the U.S. banking agencies are about to embark on a sweeping reform of the risk-based capital framework as part of their expected Basel III Endgame reforms. These changes could increase bank capital requirements “by up to 20%” in the aggregate for the largest U.S. banks, driven in large part by close to a 60% increase^[2] in market risk capital requirements for the Global Systemically Important Banks (GSIBs).^[3] These increases will likely have significant impacts on the ability of banks to support capital markets activities and economic activity more generally, leading to reduced liquidity in many key funding markets and increased financing costs for businesses and consumers.

This raises the important question of what the “optimal” level of capital should be; that is a level that maximizes the financial stability benefits of increased capital without being so high as to impair economic growth, lending, and capital markets activities. A recent study released by PricewaterhouseCoopers LLP (PwC) entitled ”Basel III Endgame: The next generation of capital requirements” examined this issue in-depth in the context of the expected implementation of the Basel III Endgame reforms. The study provides a comprehensive overview of the post-GFC U.S. prudential regulatory framework, noting how the myriad reforms (and their interactions with one another) have reduced risks in the financial system. It then surveys the academic literature on the benefits and costs of bank capital, finding that the average optimal level of capital predicted by those papers is close to the current level of capital at the largest U.S. banks. Moreover, the PwC report notes that many of these studies may not fully account for the risk-reducing impact of other prudential reforms beyond capital requirements and may therefore potentially be overestimating the marginal benefit of higher capital requirements – and by extension the optimal level of capital in the banking system.

Below, we highlight some of the key findings from the PwC report, including an overview of the post-GFC prudential regulatory reforms and their cumulative impact on the safety of the banking system; discuss PwC’s findings with respect to the optimal level of capital; and discuss some of the potential capital markets impacts of the expected increases in capital resulting from the Basel III Endgame.

What Are the Components of the Post-GFC U.S. Prudential Regulatory Reforms?

Since the GFC, banks – particularly the largest U.S. banks – have become subject to a vast and complex array of rules and supervisory standards designed to mitigate a wide range of risks to both individual institutions and the financial system more generally. Table 1 below lists the major components of the different regulatory requirements and supervisory standards applicable to banks in each tiering category (with “Category 1” representing the largest U.S. banks – the eight U.S. GSIBs).^[4]

Table 1. The Components of the current U.S. prudential regulation standards by tiering categories.

As Table 1 illustrates, the U.S. GSIBs are required to comply with the most stringent prudential requirements. These requirements are designed to reduce risks in the banking system through the following means:

• Increasing the quantity and quality of banks’ capital and liquidity. The increase in capital was achieved in part, as we previously noted, through the implementation of the original Basel III capital reforms in 2013. Some of the largest impacts, however, occurred through the implementation of capital buffers, including the GSIB Surcharge and the Stress Capital Buffer (“SCB”). Capital increases were also driven by the standard and enhanced Supplementary Leverage Ratio (“SLR”) and the statutory Collins’ Floor. Moreover, in practice, banks generally maintain capital buffers above and beyond regulatory-mandated minimum levels to prevent breaches of regulatory requirements which in some cases carry mandatory restrictions on capital distributions or other penalties for breaches. In addition, the Total Loss Absorbing Capital (“TLAC”) was created to support the orderly resolution of a failing GSIB without the need for taxpayer support. Beyond capital, liquidity resources have been increased through the creation of two standardized requirements: the Liquidity Coverage Ratio (“LCR”) and the Net Stable Funding Ratio (“NSFR”), which are designed to ensure banks have sufficient liquid assets to weather liquidity stresses over both a short-term and longer-term horizon.
• Ensuring banks’ resiliency under stress conditions via stress testing. Stress tests assess banks’ capital and liquidity adequacy by evaluating whether they can withstand a pronounced stressed macroeconomic environment that is either prescribed by regulators (supervisory capital stress tests such as the Comprehensive Capital Analysis and Review or “CCAR”) or by the banks’ internal risk models (company-run capital stress tests). Banks are also required to conduct internal liquidity stress tests (“ILST”), and the largest banks are subject to the horizontal Comprehensive Liquidity Analysis and Review (“CLAR”) that the Federal Reserve conducts annually.
• Reducing counterparty and trading risks. Regulators have put in place a series of rules designed to limit counterparty and trading risks. These include, among other things, central clearing and margin requirements for non-cleared derivatives, single-counterparty credit limits, and the Volcker Rule which prohibits banks from engaging in proprietary trading or investing in/sponsoring hedge funds or private equity funds.
• Creating supervisory programs to complement regulatory requirements and enforce compliance with heightened expectations. In addition to stress testing banks’ capital resiliency, the CCAR and Dodd-Frank Act Stress Tests (“DFAST”) also evaluate large banks’ capabilities in capital planning, while CLAR evaluates the largest banks’ liquidity risk management practices and resiliency under normal and stressed conditions. Large banks are required to prepare resolution plans and are subject to regular exams that assess whether they could be unwound in an orderly manner that does not undermine financial stability.  Embedded in these supervisory programs are qualitative criteria that complement the minimum quantitative requirements set out in the rules.  And they allow the regulators to take firm-specific regulatory actions to ensure any idiosyncratic risks are appropriately addressed.
• Requiring supplemental enhancements to risk management. A range of requirements have been put in place to enhance risk management, governance, identification, and measurement. These include, for example, heightened requirements and expectations for boards of directors in overseeing a bank’s risk management governance and practices.

Collectively, these requirements and standards have dramatically raised U.S. GSIBs’ capital and liquidity resources and have also reduced a range of other risks to banks and the broader financial system.  As shown in Figures 1-3 below^[6], U.S. GSIBs’ common equity tier 1 (“CET1”) capital (the highest-quality form of bank capital) has tripled since the GFC, while TLAC grew by approximately 6 times, and the amount of high-quality liquid assets (“HQLA”) held by banks – a key measure of liquidity resilience – increased nearly 11-fold during the same period.

Figure 1. Aggregate Level of Common Equity Tier 1 of U.S. GSIBs.

Figure 2. Aggregate Level of High-Quality Liquid Assets of U.S. GSIBs.

Figure 3. All Usable Total Loss Absorbing Capacity of U.S. GSIBs.

As a result of all of these changes, the likelihood of a GSIB failure has declined dramatically and the resiliency of the financial system has increased. Capital levels in particular are extraordinarily robust compared to their pre-GFC levels. Yet, the U.S. banking regulators look set to propose a significant increase in capital requirements as part of the Basel III Endgame reforms. This raises the question of whether these additional expected increases would add marginal benefits to financial stability that would outweigh their economic costs, particularly when considered in the context of all of the other post-GFC reforms.

What Is the Optimal Level of Bank Capital?

In order to identify the optimal level of capital for the largest U.S. banks, PwC conducted a comprehensive review of the existing literature on optimal bank capital levels. Much of the literature evaluates optimal capital levels by comparing the trade-off between the marginal benefits of higher capital in promoting financial stability and the marginal costs in terms of its potential impact on economic growth. The studies generally find that higher capital levels promote financial resiliency by increasing banks’ loss-absorbing capacity thereby reducing the likelihood of bank failures and systemic crises.  However, they also observe that higher capital levels can impair economic growth by raising the cost of credit and potentially limiting the availability of financing, which may reduce investment and economic expansion.

 PwC focuses on six papers out of over twenty they reviewed, the conclusions of which are summarized in Figure 4 below. The papers identify 12-19.5% as the optimal range for Tier 1 capital,[7] with an average of 15.5%.  This figure aligns closely with the actual average U.S. GSIBs Tier 1 capital ratios of 15.5% and 15.2%, as of the fourth quarter of 2021 and 2022, respectively. The corresponding implied optimal CET1 ratio is estimated to be 13.8%.^[8]  This figure is aligned with the average U.S. GSIBs’ CET1 ratio as of year-end 2021 and 2022 of 13.7% and 13.2%, respectively.  As noted above, banks generally maintain capital buffers above and beyond regulatory-mandated minimum levels to prevent breaches of regulatory requirements in order to accommodate their specific risk profiles and capital strategies.

 Figure 4. Optimal Tier 1 Capital Estimates Across Select Studies.^[9]

The PwC report observes that while many of these papers try to account for some of the post-GFC regulatory reforms in determining the optimal level of bank capital, none of them include a holistic evaluation of the costs and benefits of increased capital given all of the post-GFC prudential reforms. In particular, they generally do not account for the risk reduction effects of increases in TLAC and liquidity resources at the largest U.S. banks, or the increased strength in risk management processes that has resulted from the regular stress testing of capital and liquidity at these institutions. Similarly, the reductions in counterparty and trading risks and other reforms are not fully accounted for in these studies. Moreover, none of the studies accounts for possible financial stability risks that may arise from an increase in bank capital requirements, such as risks that might arise from activities migrating to less regulated sectors of the financial system. In sum then, this implies that the marginal benefit of higher capital levels identified by these studies may be overstated, and thus the optimal level of capital for the largest banks may be in fact lower than the figures cited above.

What Will be the Impact of Higher Capital Requirements on Large Banks’ Capital Markets Activities?

In its February 2023 Basel III Monitoring Report, the Basel Committee on Banking Supervision (“BCBS”) estimates the weighted average expected increase in market risk capital – the capital charge for large banks’ capital market activities – as the result of the Basel III Endgame will be 56.5% for global GSIBs,^[10] a figure that is likely an underestimate in the U.S. context for reasons we discussed in Part II of this blog series. These increases, driven by the component of the Basel III Endgame known as the Fundamental Review of the Trading Book (“FRTB”), will affect banks’ ability to provide several core capital markets services to their clients, including securities underwriting and market-making, and facilitation of commercial end-users engaging in hedging interest rate and foreign exchange risks.

We estimate some of these effects below.^[11] Figure 5 below plots the U.S. GSIB’s aggregate trading assets/liabilities between 2017-2023 (green line); the effective Risk Weighted Asset (“RWA”)^[12]risk weight (also referred to as RWA density) under the current market risk rule – Basel 2.5 (blue bar); the effective RWA risk weight under the Global Market Shock (“GMS”) and Largest Counterparty Default (“LCD”) losses that are mandated as part of the SCB requirement (yellow bar)^[13]; and the effective RWA risk weight add-on (estimated to be 8.36% as of December 31, 2022)^[14] that we expect as a result of the FRTB relative to the current market risk rule (blue dotted bar). The red line represents the 65% risk weight assigned by regulators to investment grade (“IG”) corporates under the Basel III Endgame standardized credit risk framework; a larger effective RWA risk weight corresponds to a higher capital requirement.

The chart demonstrates that: (1) the aggregate trading assets/liabilities of banks fall as capital requirements increase (Table 2 quantifies the impact); (2) the GMS/LCD hypothetical losses are many times the possible stress losses that have occurred since 2007 (banks are required to calibrate market risk based on a historical stress period dating back to 2007); (3) the aggregate trading assets/liabilities are treated in the same way as high-yield debt for capital purposes since the effective RWA risk weight fluctuates around 100% and is consistently above 65% (which is the risk weight for investment grade corporates).

Figure 5.  U.S. GSIBs’ Aggregate Trading Assets/Liabilities and the Effective RWA Risk Weight Resulting from Market Risk Rule (Basel 2.5 and FRTB) and SCB GMS/LCD Hypothetical Losses.

 To quantify the interaction between capital requirements and the U.S. GSIBs’ aggregate trading assets/liabilities, Table 2 conducts a linear regression analysis (more details on the quantitative analysis involved are included in an appendix to this blog post). The coefficient for the effective risk weight is highly significant statistically and economically. Economically, for every one percentage point increase in the effective risk weight, U.S. GSIBs’ aggregate trading assets/liabilities falls by $16.26bn.  As a result, the expected FRTB effective RWA add-on risk weight of 8.36% would translate into a potential reduction in U.S. GSIBs’ aggregate trading assets/liabilities of roughly $136bn, had the FRTB been in effect as of December 31, 2022.

Table 2.  The Relation between Capital Requirements U.S. GSIBs’ Aggregate Trading Assets/Liabilities.

The effect of these increases in market risk capital would thus likely be to further constrain the largest banks’ ability to support capital market activities, including securities underwriting.  This would accelerate a trend: U.S. GSIBs’ market shares for equity, corporate, and municipal debt issuances have been declining steadily since 2009^[16], as illustrated in Figure 6 below.  The continued reduction in banks’ ability to support capital market activities likely will lead to diminished liquidity, more frequent flash crashes, and heightened financial stability risk, especially during market stresses. Given the importance of capital markets funding for non-financial corporations, it will also mean higher funding costs and reduced availability of credit to a wide range of businesses and ultimately consumers.

Figure 6.  U.S. GSIBs’ Market Shares in Equity, Corporate, and Municipal Underwritings.

Conclusion

Bank capital is not costless. As we have shown in this blog, increases in market risk capital requirements will lead to a decrease in the aggregate trading assets and liabilities for the largest U.S. banks, with knock-on negative effects on the ability of corporations and other end-users to obtain affordable financing. In addition, PwC’s survey of the literature on the cost of bank capital suggests that U.S. GSIBs’ current capital levels are near their optimal levels, particularly when factoring in the risk-reducing effects of other prudential requirements. This suggests that further significant increases in capital requirements, such as those envisioned under the Basel III Endgame, will result in material costs to the capital markets and the broader economy that will not be outweighed by any marginal financial stability benefits.

Regulators should therefore carefully weigh the costs and benefits of these capital reforms to ensure that they achieve an appropriate balance between financial stability and broader economic growth. In particular, we encourage regulators to consider the interactions between the Basel III Endgame reforms and existing elements of the U.S. capital regime, and holistically evaluate whether other parts of the U.S. capital framework ought to be amended in light of the Endgame reforms.

 

Dr. Guowei Zhang is Managing Director and Head of Capital Policy for SIFMA.

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

Mr. Carter McDowell is Managing Director and Associate General Counsel for SIFMA.

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APPENDIX: Quantitative Analysis on the Interaction of Market Risk Capital Requirement and Trading Assets/Liabilities

We construct a sample of effective risk weight and aggregate trading assets/liabilities covering the period of 1Q 2017 – 4Q 2022 and the eight U.S. GSIBs that are subject to both the market risk rule and the GMS/LCD component of the SCB.  The eight U.S. GSIBs are Bank of America Corporation, The Bank of New York Mellon Corporation, Citigroup Inc., Goldman Sachs Group, Inc., JPMorgan Chase & Co., Morgan Stanley, State Street Corporation, and Wells Fargo & Company.  Collectively, these eight largest banks account for the majority of all U.S. banks’ capital market activities, and 92% of the $100bn GMS/LCD losses in the 2022 supervisory stress test exercise.

Market risk RWAs are reported in FFIEC 102, and trading assets and liabilities are reported in FR Y9-C.  FFIEC.GOV posts the most recent 5-year data.  Historical GMS/LCD losses can be downloaded here. Generally, to convert capital requirement (or losses) to RWA the capital rules require multiplying the capital requirement by 1/8% (or 12.5).  The 8% corresponds to the 8% minimum risk-based capital requirement set out by the Basel standards, which consists of 4.5% of CET1, 1.5% Additional Tier 1, and 2% of Tier 2. A detailed definition of the three categories of regulatory capital can be found here. Because the SCB sets out minimum requirement on CET1, rather than total capital, we calculate GMS/LCD equivalent RWA by multiplying the GMS/LCD losses by 1/4.5% instead of 1/8%.

The BCBS estimates that the FRTB is expected to increase market risk capital requirement by 56.5% for global GSIBs relative to the current market risk capital framework. The market risk RWA under the FRTB is approximated by 1.565x of the RWA reported in FFIEC 102.  The RWAs and trading assets/liabilities are aggregate across the eight U.S. GSIBs. And the effective risk weight (also referred to as RWA density) is calculated as the ratio of the aggregate RWA to the aggregate trading assets/liabilities. We estimate a linear regression model with the aggregate trading assets/liabilities as the dependent variable, and the independent variables are the effective risk weight plus a constant. Table A1 below reports the results. We caution that because of the short historical period and resulting small sample size, the results may underestimate or overestimate the actual impact of capital requirements on trading activities over a longer period of time.

Table A1.  The Relation between Capital Requirements U.S. GSIBs’ Aggregate Trading Assets/Liabilities

The coefficient for effective risk weight is highly significant statistically and economically.  Economically, for every one percentage point increase in effective risk weight, the aggregate trading assets/liabilities falls by $16.26bn. As of December 31, 2022, had the FRTB been in effect the market risk effective risk weight would have been 8.36% higher, which translates into a potential reduction in the aggregate trading assets/liabilities of roughly $136bn.

^[1] https://www.federalreserve.gov/publications/files/svb-review-20230428.pdf

^[2] [Add in citations of Barr and Quarles statements and Basel monitoring report].

^[3] As we discussed in Part II of this series, that number may well be an underestimate, given the interaction between the capital changes for banks’ trading activities and other elements of the U.S. capital framework.

^[4] https://www.federalregister.gov/documents/2019/11/01/2019-23800/changes-to-applicability-thresholds-for-regulatory-capital-and-liquidity-requirements

^[5] The GMS component for the severely adverse scenario applies to a firm that is subject to the stress test and that has aggregate trading assets and liabilities of $50 billion or more, or aggregate trading assets and liabilities equal to 10 percent or more of total consolidated assets, and that is not a Category IV firm under the Board’s tailoring framework.  For CCAR 2023 the following banks are subject to GMS or LCD: Bank of America Corporation, The Bank of New York Mellon Corporation, Barclays US LLC, Citigroup Inc., DB USA Corporation, The Goldman Sachs Group, Inc., JPMorgan Chase & Co., Morgan Stanley, State Street Corporation, and Wells Fargo & Company.

^[6] Figures 1-3 were taken from the PwC study.

^[7] Tier 1 capital is the sum of Common Equity Tier 1 and Additional Tier 1 capital, net of certain regulatory adjustments.  The predominant form of Tier 1 capital consists of common shares and retained earnings.

^[8] PwC’s estimate for the implied optimal CET1 ratio is derived by multiplying the midpoint Tier 1 optimal capital estimate by the quarterly average historical ratio of CET1 to Tier 1 capital ratios across GSIBs from 1Q2018 to 4Q2022. The relationship between CET1 and Tier 1 capital ratios across GSIBs has been stable since 2018.

^[9] Figure 4 was taken from https://explore.pwc.com/baseliiiendgame/basel-iii-end-game-report#page=1 and detailed references can be found therein.

^[10] https://www.bis.org/bcbs/publ/d546.pdf

^[11] See Appendix for more technical details.

^[12] The effective RWA risk weight is calculated as the ratio of aggregate market risk RWA, reported in FFIEC 102, to aggregate trading assets/liabilities, reported in FR Y9-C. The higher the effective risk weight the higher the capital requirement.

^[13] The GMS/LCD losses are multiplied by 1/4.5% to convert to the corresponding RWA.  The resulting effective RWA risk weight is calculated the same way as in FN8.

^[14] The BCBS estimates that the FRTB is expected to increase market risk capital requirement by 56.5% for global GSIBs relative to the current market risk capital framework (Basel 2.5).  As of December 31, 2022, the effective RWA risk weight under Basel 2.5 is 14.8% and 56.5% of which equals to 8.36%.

^[15] https://www.federalreserve.gov/supervisionreg/dfast-archive.htm

^[16] In 2009, the first Supervisory Capital Assessment Program (“SCAP”) was put in place, which set out additional capital requirements for large banks’ capital market activities via the GMS and LCD losses. The SCAP was replaced by CCAR in 2011 which was then incorporated into the risk-based capital requirement through the SCB in 2020.

Related Resources

• Pennsylvania + Wall Blog

  Blog Series on US Bank Capital Requirements

• REPORT

  Basel III Endgame: The Next Generation of Capital Requirements

  This report by PwC evaluates the literature by regulators, international standard setting bodies and academics that seeks to identify an optimal level of capital.