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Our Take on PwC’s Assessment of the US Basel III Endgame Proposal

  • On June 17, 2024, PwC released Part II of their Basel III Endgame study. The study finds that the U.S. Basel III Endgame proposal (“the Proposal”), if implemented, would cause the U.S. economic growth to decline by up to 56 basis points or half of a percent. This would equate to a reduction in growth of up to 25% based on the U.S. compound annual growth rate over the past 10 years. The negative impacts likely would materialize as reduced returns to bank shareholders (including indirect shareholders through pensions and mutual funds) and through increased costs to consumers and businesses.
  • Part I of the study was published in April 2023. This part evaluated the optimal capital level and found that current capital level of large U.S. banks stands at the average optimal capital level suggested in studies of the topic by regulators, international standard setting bodies and academics.
  • The banking agencies need to consider (1) whether the U.S. banking system needs significantly more capital (if so, how much more is required) and (2) what are associated costs (and benefits) to the broader economy and consumers of the Basel Endgame proposal as they decide the next steps in the rulemaking process.

The Proposal is expected to have material negative impact to GDP and increase costs to consumers.

Since the release of the Proposal in July 2023, various stakeholders have been evaluating its potential impacts and have provided comments to the banking agencies. Latham & Watkins reported that over 97% of comment letters the agencies received either opposed the Proposal and/or called for a re-proposal, or expressed significant concerns with the Proposal.

Utilizing a framework similar to a 2019 Federal Reserve staff paper that evaluates the economic costs and benefits of bank capital in the U.S., Part II of the PwC study finds a negative ongoing GDP impact across three different economic scenarios: -17 bps (positive), -36 bps (neutral) and -56 bps (negative). Put differently, the Proposal would cause the U.S. economic growth to decline by up to 56 basis points – approximately 25% based on the U.S. compound annual growth rate over the past 10 years of 2.1%.

Part II of the study then dives into the impacts on several business segments (including credit cards, residential mortgages, corporate loans and lines of credit, SFTs, derivatives and securitized products) and finds “[a]n increase in capital requirements will lead to reduced lending and higher borrowing costs.” The Proposal is expected to impact industry stakeholders in different ways:

Basel III Endgame Proposal impact chart

Part II provides quantitative estimate of the Proposal’s impacts by product type:

  • Derivatives: Additional capital requirements for derivatives could require banks to pass on additional costs of $10.4 billion per annum to end-users. In particular, the cost to hedge interest rate risks would likely increase by nearly 10 bps, i.e. about $1 million annually per $1 billion of swaps notional. Such an increase is an order of magnitude over the bid-offer typically seen on liquid swaps and comes on top of a rate environment that has increased over 500 bps in the last two years.
  • Securitized Products: Changes to the securitization framework could result in the risk weights for certain tranches of mortgage-backed securities increasing by 250%.
  • Credit Cards/Credit Lines: The 10% credit conversion factor applied to unused lines of credit and lower risk weight for transactor exposures would incentivize banks to reduce credit lines for all customers and reduce credit exposure to segments with traditionally lower credit scores.
  • Residential Mortgages: Incremental capital costs from higher loan-to-value bands would affect $1.46 trillion in outstanding first lien mortgages, possibly reducing credit availability for expanding homeownership.
  • Corporates: Distinctions in capital treatment between publicly listed and private companies, including regulated entities unable to publicly issue securities (e.g., mutual funds and pension funds), would incentivize banks to treat customers differently despite similar credit risk profiles.
  • SFTs: The SFT minimum haircut floor framework drives the increase in risk-weighted assets (RWA) requirements for SFTs, totaling approximately 20% of the total RWA attributable to SFTs for U.S. banks.

In addition, Part II highlights that the “[d]ifferences between the U.S. proposal and adoption of the Basel Framework in other jurisdictions could result in different capital treatment for similar risks across global banks.” Such differences would undermine the goal of having globally consistent capital requirements and create a misalignment of risk, whereby capital requirements for the same risks would differ by jurisdiction:

  • The effective risk weights in the Proposal are 18-35% higher for investment grade corporates and 27-59% higher for other corporates when compared to the original Basel framework.
  • Risk weights for retail exposures are 10% higher in the U.S. than the original Basel framework, which would drive effective RWA requirements for U.S. banks up by approximately 14%.
  • Without the adoption of the simple, transparent, and comparable framework, risk weights for securitizations would be 47% higher for auto asset-backed securities, 68% higher for collateralized loan obligations, and 26% higher for residential MBS relative to the Basel framework.
  • The SFT minimum haircut floor framework (which was not adopted by all other major jurisdictions) is the largest component driving an increase in RWA requirements for SFTs for U.S. banks. Without it, RWA for SFTs would decrease by approximately 7% from their current levels.

Large US banks’ current capital level is at the optimal level.

The primary objective of bank capital requirements is to reduce the likelihood of individual bank failures and subsequent negative effects on the banking system and financial markets, thereby bolstering financial stability. However, such required capital does not come without costs. Excessive capital requirements can negatively impact economic growth by raising the cost of lending and reducing the availability of financing and capital markets products/services for corporations and consumers.

What is the optimal capital level that appropriately balances the benefits and costs of required capital? Where does large U.S. banks’ capital levels stand relative to that optimal level? These are the questions that PwC addressed in Part I of their study.

Part I surveyed published reports and papers by regulators, international standard setting bodies and academics that seek to identify an optimal level of bank capital. It found that “the optimal capital ratios range is 12-19.5%, with an average estimate of 15.5%. This figure aligns closely with the actual average tier 1 bank capital ratios of 15.5% and 15.2%, as of the fourth quarter of 2021 and 2022, respectively, for bank holding companies that are expected to be subject to Basel III Endgame capital requirements.” That is, large U.S. banks’ current capital levels are in line with the average estimated optimal level of capital.

However, the Proposal (together with the GSIB surcharge proposal) is expected to increase aggregate capital requirements for largest U.S. banks by 30%. For these banks’ trading and market-making business, the SIFMA/ISDA quantitative impact study showed that the Proposal’s revised market risk framework (i.e., FRTB) would raise aggregate capital requirements by about 73% under the modelled-approach and over 100% under the regulator-set standardized approach. Such further material increases in capital requirements from the current robust levels likely would result in the economic costs outweighing any potential benefits as Part II of the PwC study shows. This is particularly true because approximately 75% of capital formation and lending happens in the capital markets in the U.S., meaning that the trading book capital reforms will have an outsized impact on the U.S. economy.

Conclusion

Post the Global Financial Crisis, global and domestic standard setters have instituted a suite of enhanced capital regulations and supervisory mechanisms.1 As a result, the overall level of capital in the system has quadrupled and key capital ratios roughly doubled due to significant increases in capital requirements. Beyond capital requirements, many other measures have also been implemented to enhance resiliency of the financial system, e.g., liquidity and total loss absorbing capital requirements, limits on counterparty exposures and restrictions on trading activity. As the banking agencies deliberate the next steps in the Basel Endgame rulemaking process, they should consider: (1) whether the U.S. banking system needs significantly more capital (if so, how much more is required)? and (2) what are the relative costs and benefits to the broader economy, businesses and consumers?

PwC’s two-part study on the Basel III Endgame attempts to answer these two questions. Part I evaluated the optimal bank capital level and found that the current capital level of banks expected to be subject to the Proposal is at the average optimal capital level suggested by the literature by regulators, international standard setting bodies and academics that seeks to identify an optimal level of capital. Part II assesses the impacts of the U.S. Basel III Endgame proposal and concludes that the Proposal could cause U.S. economic growth to decline by up to 56 basis points, equivalent to a 25% decline in growth based on the U.S. compound annual growth rate (i.e., 2.1%) over the past 10 years. The negative impacts likely would materialize in the form of higher costs and reduced access for a wide range of capital markets participants, and through increased costs to U.S. businesses and consumers.

Author

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

Footnotes

  1. Including: (1) increasing the amount and quality of banks’ financial resources; (2) introducing stress testing of financial resources and other forward-looking loss estimation techniques; (3) reducing counterparty exposures and risk in trading activities; (4) creating new supervisory programs to complement new regulatory requirements and enforce compliance with the heightened expectations; and (5) requiring supplemental enhancements to risk management. [↩]

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