Federal Reserve to Revise Bank Capital Rules, Emphasizing Risk-Based Approach

The Federal Reserve is set to revise its proposed capital rules for banks, emphasizing a more nuanced, risk-based approach. Michael S. Barr, Vice Chair for Supervision at the Federal Reserve, unveiled these plans in a recent speech at the Brookings Institution, signaling a significant shift in how regulators view bank resilience and risk management.

The centerpiece of this regulatory overhaul is the re-proposal of the Basel III endgame and the global systemically important bank (G-SIB) surcharge rules. This decision comes after extensive feedback from various stakeholders, including banks, academics, and public interest groups. "We have concluded that broad and material changes to the proposals are warranted," Barr stated, highlighting the Fed's responsiveness to industry concerns.

At the heart of these changes is a tiered approach to regulation, recognizing that one size does not fit all in the banking sector. The largest and most complex banks, known as G-SIBs, will face the most stringent requirements. These institutions could see their common equity tier 1 capital requirements increase by an estimated 9%. This move reflects the Fed's continued focus on mitigating systemic risk in the financial system.

However, smaller banks won't be left unscathed. Those with assets between $100 billion and $250 billion will see some changes, primarily in how they account for unrealized gains and losses on securities in their regulatory capital. This adjustment, stemming from lessons learned in recent bank failures, aims to better reflect interest rate risk in capital calculations.

The proposed revisions extend beyond just capital ratios. Barr outlined significant changes to how banks calculate risk-weighted assets, a crucial component in determining capital requirements. Risk weights for residential real estate and retail exposures are set to decrease, potentially influencing lending strategies across the industry. Additionally, the treatment of operational risk is being overhauled, with a move towards net income-based calculations for fee activities.

For risk managers and compliance officers, these changes signal a need for comprehensive reviews of existing models and strategies. The extended implementation periods for new market risk tests provide a window for banks to refine their internal models and processes. Meanwhile, governance structures will need to adapt, with boards and senior management reassessing capital allocation strategies and risk appetite statements in light of the new regulatory landscape.

The G-SIB surcharge calculation is also getting a makeover. In a nod to evolving market conditions, Barr proposed adjusting the methodology to account for economic growth and inflation. This change aims to ensure that a bank's surcharge doesn't increase simply due to overall economic expansion, focusing instead on its relative systemic importance.

Interestingly, the Fed is backing away from some previously proposed changes. For instance, the minimum haircut floors for securities financing transactions won't be adopted, allowing time for greater international consensus on this issue. Similarly, the capital treatment for client-cleared derivatives is being adjusted to avoid disincentivizing central clearing, a critical tool for reducing systemic risk.

These revisions reflect a delicate balancing act by the Federal Reserve. On one hand, they aim to strengthen the resilience of the banking system, particularly in light of recent bank failures. On the other, they acknowledge the need for efficiency and the important role banks play in supporting economic growth. "It is most imperative that we get this right," Barr emphasized, underscoring the high stakes involved.

Governor Michelle Bowman's Speech on the Stress Capital Buffer Framework

The Federal Reserve's proposed revisions to its capital rules come at a time of broader reflection on the effectiveness of existing frameworks. Governor Michelle W. Bowman’s recent speech on the Stress Capital Buffer Framework adds crucial context. As she emphasized, stress testing remains a valuable tool for assessing bank resilience, but the current framework has notable drawbacks that need addressing. These issues include volatility in stress test results, the link between stress testing and capital, and a lack of transparency that makes it difficult for banks to plan effectively.

Bowman highlighted concerns that the year-to-year variability in test results creates unpredictability for banks, especially regarding the stress capital buffer. This variability can make long-term capital planning challenging, as banks often must respond to unexpected shifts in their required buffers. For example, this year’s results showed banks would need to comply with new capital requirements by October 1, 2024, leaving a narrow window for adjustments. Such short timeframes can disrupt management buffers and require firms to hold more capital than necessary.

Bowman also called for a reassessment of the stress testing process, questioning whether a single stress scenario—such as the severe hypothetical shocks used this year, including a 40% drop in commercial real estate prices and a 10% unemployment spike—is enough to inform capital decisions. She suggests a more robust approach, potentially testing multiple scenarios to better reflect different economic stresses, though she cautions against using these tests to justify further capital increases across the board.

Moreover, Bowman underscored the need for greater transparency in the stress testing models, arguing that banks should have more visibility into the parameters that regulators use. Currently, the opaque nature of these models leaves banks guessing how stress test outcomes will impact their capital requirements. While critics fear that too much transparency might allow banks to "game" the system, Bowman believes that careful review and dynamic updates to stress testing can mitigate those risks without sacrificing clarity.

Another key point from Bowman's speech is the overlap between stress testing and other capital rules, such as those governing market risk under the Basel III endgame proposal. She warned that if these frameworks are not properly aligned, they could lead to over-calibration of capital requirements, potentially hindering U.S. banks' participation in global markets.

These concerns align with Michael S. Barr's emphasis on striking a balance between resilience and efficiency. While Barr’s proposals would increase capital requirements for the largest banks by 9%, Bowman’s call for a more nuanced application of stress testing points to the broader debate on how much capital banks should hold in the face of systemic risks. The revisions proposed by Barr, including changes to risk-weighted asset calculations and G-SIB surcharges, aim to address systemic vulnerabilities while allowing banks to support economic growth—an ambition that Bowman supports, though with more caution around capital calibration.

Together, these insights highlight the complexity of the regulatory landscape and underscore the importance of ongoing dialogue between regulators, banks, and the public. For compliance and risk professionals, Bowman’s remarks reinforce the need for a proactive approach in adjusting capital strategies and ensuring alignment with evolving stress testing protocols. The stakes remain high, as both Barr and Bowman agree: getting these regulations right is critical for maintaining the stability of the financial system while ensuring banks remain competitive.

As the financial industry digests these proposed changes, banks of all sizes will need to carefully evaluate their impact on their operations, risk management practices, and strategic planning. The Fed's decision to re-propose these rules and accept public comments on all aspects provides an opportunity for further refinement and industry input.

For governance, risk, and compliance professionals, the message is clear: stay alert and be prepared to adapt. As these proposals move towards implementation, they will undoubtedly shape the regulatory landscape for years to come, influencing everything from capital allocation to business models in the banking sector.

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