• In the U.S., capital markets serve as a vital source of funding and financial risk management products and services for the economy. U.S. GSIBs (and foreign GSIBs operating in the U.S.) are instrumental intermediaries in the U.S. capital markets. Data suggests that the proposed Basel 3 Endgame would materially raise capital requirements for banks’ capital markets activities.
• Banks allocate equity capital to each business segment considering many factors including regulatory capital requirements for the business activities. Materially higher regulatory capital requirements for capital markets activities would result in certain businesses becoming less economically viable. Likely fewer capital markets products and services would be offered – diminishing market liquidity – and at higher costs.
• Therefore, the Federal Reserve should pay particular attention to impacts on banks’ capital markets businesses when deliberating revisions to the proposal.

1. The Basel 3 Endgame proposal is expected to materially raise regulatory capital requirements on banks’ capital markets activities.

In the U.S., capital markets serve as a vital source of funding and financial risk management products and services for the economy, e.g., providing 72% of equity and debt financing for non-financial corporations as of 2023.^[1] U.S. GSIBs (and foreign GSIBs operating in the U.S.) are instrumental intermediaries in the U.S. capital markets.^[2] This blog dives into the major components of the Basel 3 Endgame proposal that focus on banks’ capital markets activities, i.e., the Fundamental Review of the Trading Book (“FRTB”), counterparty credit risk and CVA risk frameworks.

The SIFMA/ISDA’s quantitative impacts studies (“SIFMA/ISDA QIS”)^[3] show that the FRTB alone would raise aggregate capital requirements by about 73% under the modeled approach and over 100% under the regulator-set standardized approach for U.S. GSIBs’ trading and market-making business. The impacts on individual business segments will vary. For example, the increase in capital requirements for securitized assets is expected to exceed 176%.^[4] Our securitization blog discusses in detail how the proposed changes could have severe detrimental impacts on banks’ ability to finance consumer, business, and other credit, and to make markets in securitized assets – results in increasing interest rates and reducing the availability of credit, thereby harming main street as well as U.S. financial markets’ global competitiveness – and suggests mitigation actions.^[5]

Additionally, the SIFMA/ISDA QIS indicates that the proposed counterparty credit risk and CVA risk frameworks are expected to increase capital requirements by nearly 25% for these banks’ derivatives and security financing transactions (“SFTs”) businesses. For client clearing businesses, the expected increase in capital requirements is around 80% while for the SFTs businesses, the increase is about 18%. Derivatives (including centrally cleared derivatives) are essential financial risk management tools that are widely used by corporations, pension funds, governments, and other end-users to manage financial risks. Congress exempts end-users from mandatory clearing recognizing the importance of having ready access to derivatives markets by end-users. As a result, the Federal Reserve provides a special provision in the current capital rule to lower the capital requirements for derivatives transactions with end-users.^[6] While the SFTs market is vital for the smooth functioning of our financial system as it facilitates the flow of cash and high-quality securities across the system.^[7]

Such material increase in capital requirements would constrain banks’ capacity of intermediating capital markets which could destabilize these vital markets and adversely impact financial stability.

2. The regulatory capital requirements drive banks’ allocation of equity capital to each business segment.

In practice, banks generally allocate capital down to each business segment. The amount of capital assigned to each business segment is commonly referred to as equity capital or equity. Each bank has its own internal capital allocation framework. But generally, these frameworks would consider multiple factors, including banks’ internal assessment of risks, the regulatory capital requirements (inclusive of applicable buffer requirements, e.g., Stress Capital Buffer or “SCB”) related to the business activities, and each business segment’s relative contribution to the total required capital.

Return on equity (“ROE”) is measured and internal targets for expected returns are established as key measures of a business segment’s performance.^[8] The economic viability of those business segments that fail to meet their ROE targets may be at risk.^[9] A recent Oliver Wyman report projected that the expected increase in capital requirements associated with the Basel 3 Endgame proposal would generate up to a “6pt [i.e., 6%] drag on ROE for these players” and likely that “[b]anks pare back activities as they become increasingly uncompetitive; revenues and RWA shrink”. The report identified derivatives, securitized assets, and SFTs among the business segments that would be severely impacted by the proposal.

3. The Federal Reserve could take a set of actions to mitigate the Basel 3 Endgame proposal’s impacts on banks’ capital markets activities.

The SIFMA/ISDA QIS and empirical analyses (e.g., SIFMA’s GMS study) suggest that the key drivers of the over-calibrated capital requirements for banks’ capital markets activities include (1) the overlap in risk capture by the SCB and the Basel 3 Endgame (i.e., market risk, CVA risk and operational risk), (2) the lack of recognition of diversification benefits across different asset classes under the FRTB, (3) the lack of incentive for banks to adopt the FRTB modeled approach, and (4) the draconian consequence associated with the proposed SFT minimum haircut floor framework. Additionally, the treatment of fee-based businesses and reimbursement for services that U.S. affiliates receive from their foreign parent under the proposed operational risk framework leads to outsized operational risk capital requirements.

The SCB capitalizes potential losses arising from market risk, CVA risk, and operational risk under stressed market conditions. The current capital rules apply the SCB to the U.S. standardized approach which captures only market risk and credit risk. As a result, there is an overlap in capitalization of market risk between the SCB and the current risk-weighted asset (“RWA”) framework (see our separate blog for detailed discussions). The Basel 3 Endgame proposal, however, would apply the SCB to the expanded risk-based approach (“ERBA”) which captures all four risk types. Consequently, the proposal would broaden the overlap in risk capture between the SCB and the RWA framework to include CVA risk and operational risk as well. The overlaps in risk capture results in excessive capital required in terms of dollar amount. Potential solutions include: (1) applying the SCB only to the U.S. standardized approach (same as the current capital rules, which would avoid overlapping capture of CVA risk and op risk), and (2) applying the FRTB and the SCB’s Global Market Shock (“GMS”) sequentially or using the GMS to address any inadequate risk capture, as seen by the Federal Reserve, by the RWA framework – an approach conceptually consistent with the practice in other major jurisdictions, e.g., European Union.

The complete disallowance of recognition of diversification benefits across asset classes under the FRTB standardized approach and the very limited recognition under the FRTB-modeled approach tend to penalize banks that facilitate trading and market-making in multiple asset classes. And could incentivize monoline business models which would leave the overall banking system more vulnerable. To address such adverse consequences, the Federal Reserve could allow greater recognition of diversification benefits under both the FRTB standardized approach and the modeled approach.^[10]

The SIFMA/ISDA QIS indicates that the FRTB-modeled approach does lead to lower capital increases relative to the standardized approach. However, the system required for operating the modeled approach is far more complex and costly than that of the standardized approach. And, the proposed treatment for risk factors deemed non-modellable (“NMRFs”) is overly conservative resulting in outsized capital requirements. In addition, before a bank can adopt the FRTB-modeled approach for any trading desk, the desk must pass two quantitative tests collectively known as the Profit & Loss Attribution Test (“PLAT”). The PLAT can be overly sensitive under certain circumstances resulting in unwarranted capital swings as some desks come in and out of compliance with the test. Potential solutions to incentivize the adoption of the FRTB-modeled approach could include: (1) broadening the scope of modellable risk factors,^[11] and (2) having the PLAT as a monitoring tool instead of a mandatory requirement. Or at least set out a reasonable transition period before the PLAT becomes mandatory so that both the Federal Reserve and the industry could carefully assess the performance of the PLAT.

Additionally, a careful analysis conducted by the European Bank Authority (“EBA”) led the EBA to recommend against implementing the SFT minimum haircut floor framework in the European Union due to the fact that it “could theoretically lead to a more risky situation for institutions than the status quo … while at the same time it would be unclear whether the application of the framework will have a positive effect in practice on limiting the build-up of leverage outside the banking system.” To mitigate the potential adverse impacts on the U.S. SFTs market, the Federal Reserve could remove the SFT minimum haircut floor framework from the proposal. And, to mitigate the impacts on derivatives, especially client-cleared derivatives, the Federal Reserve could exempt client-cleared derivatives from CVA capital requirements and from GSIB surcharge requirements.

4. Conclusion

Large banks are instrumental intermediaries in the U.S. capital markets which serve as the vital source of funding and financial risk management products and services for a wide array of public and private entities. Banks allocate equity capital to each business segment including capital markets businesses considering many factors including regulatory capital requirements for the business activities. And, each business segment is expected to meet the ROE target to be sustainable. The Basel 3 Endgame proposal is expected to materially increase capital requirements for banks’ capital markets activities, particularly for trading and market-making, securitized assets, derivatives, and SFTs among others. As a result, it would become more difficult for these business segments to meet their ROE targets which could mean higher costs for their clients/customers and may even endanger their economic viability. Consequently, fewer capital markets products and services may be offered, and at higher costs, leading to diminished market liquidity. Therefore, the Federal Reserve should pay particular attention to impacts on banks’ capital markets activities when deliberating the set of revisions to the proposal.

Author

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

Footnotes

[1] See https://www.sifma.org/wp-content/uploads/2022/07/2023-SIFMA-Capital-Markets-Factbook.pdf

^[2] For example, GSIBs collectively account for 88% of ABS underwriting in the U.S. as of 2023.

^[3] See https://www.sifma.org/resources/news/sifma-responds-to-u-s-basel-iii-and-g-sib-surcharge-consultations/

^[4] See https://fsforum.com/a/media/fsf—b3e-comment-letter.pdf

^[5] E.g., keep the p-factor at 0.5 under the SEC-SA framework, instead of raising it to 1 as proposed.

^[6] I.e., the alpha factor is set to 1 for commercial end-users under the SA-CCR rule. While the proposed capital increase would largely reverse the benefit of the special provision.

^[7] See https://www.icmagroup.org/assets/documents/Regulatory/Repo/GFMA-and-ICMA-Repo-Market-Study_Post-Crisis-Reforms-and-the-Evolution-of-the-Repo-and-Broader-SFT-Markets_171218.pdf

^[8] Some banks focus more on the return on tangible common equity (“ROTCE”) measure.

^[9] The ROE targets generally fall within the mid-teen percentage point range.

^[10] For the FRTB standardized approach, diversification benefits could be achieved by allowing certain correlation while aggregating asset class level capital charges. For the FRTB modelled approach, greater diversification benefits could be achieved by allowing higher IMCC correlation parameter and lower NMRFs correlation parameter.

^[11] E.g., allow daily variation margin reconciliations or valuations to be used as price observations for purpose of risk factor eligibility test.

SIFMA Resources

• US Bank Capital Requirements Blog Series

  Basel III Endgame Blog Series

• SIFMA Study

  Global Market Shock and Large Counterparty Default Study

Related Resources

• Basel III Endgame Proposal

  Regulatory Capital Rule: Large Banking Organizations and Banking Organizations With Significant Trading Activity

• European Bank Authority Analysis

  Policy Advice on the Basel III Reforms on Securities Financing Transactions (SFTs)

• Oliver Wyman Report

  Into The Great Unknown - Annual Wholesale Banking Outlook