After three large regional banks collapsed last year, the industry braced itself for blowback, not only from the public but from a regulatory perspective as well. Since the Great Recession happened roughly 16 years ago, banks have been waiting for the final phase of capital rules.
This framework, referred to as Basel III Endgame (BE3), would stipulate a wide set of requirements for the largest banks. These requirements include how much capital they would have to hold, what would count as capital, and how much capital banks would need to hold for certain types of loans and securities, among many other capital rules.
Following a lot of speculation about how the rules would shake out, it looks like banks could be heading for a positive outcome after Michael Barr, vice chair of supervision at the Federal Reserve, recently laid out his recommendations for BE3. Let's take a look.
Lower capital requirements than before
BE3 is an extraordinarily complex set of capital rules wrapped inside an extraordinarily complex process that has now taken close to two decades to hammer out. It's called BE3 because there have already been Basel I and II frameworks. In July 2023, banking regulators rolled out their initial outline for BE3. It likely came out more restrictive -- and perhaps rightly so -- after the collapse of Silicon Valley Bank, Signature Bank, and First Republic.
The proposal called for as much as a 19% hike to aggregate common equity tier 1 capital ratios for all banks with at least $100 billion in assets. The CET1 ratio is a measure of core capital (and therefore loss-absorbing capital) to risk-weighted assets (RWAs). Essentially, banks have required CET1 capital ratios each year, and excess capital above these levels is used to originate and reserve for new loans, buy back stock, and issue dividends. Higher capital requirements typically lower banks' profitability and, as such, have less capital to return to their shareholders.
Other parts of the BE3 proposal included requiring most large regional banks to include unrealized securities losses in their CET1 ratios (the four largest banks in the U.S. already do this). This was a major issue that led to the downfall of the three banks that were taken into receivership last year.
These banks were in a situation that might have required them to sell bonds at a substantial loss to cover deposit outflows, which would have wiped out shareholder equity. Including unrealized securities losses in CET1 calculations provides a more accurate reflection of a bank's capital position. The initial version of BE3 also would have required banks to hold more capital for certain loans, such as mortgages.
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Bank leaders like JPMorgan Chase's CEO Jamie Dimon blasted the initial proposal from last year on numerous occasions. In a letter to the U.S. Senate Committee on Banking, Housing, and Urban Affairs, Dimon wrote that BE3 would lead to higher interest rates and tougher access for borrowers on small business and mortgage loans, types of credit that have already been shifting to non-banks.
The pushback and lobbying efforts by large banks and other stakeholders in the industry appear to have worked. In a speech on Sept. 10, Barr said he plans to recommend that the Federal Reserve Board repropose BE3 with a set of proposals that is much friendlier to the banking industry and exclude banks with between $100 billion and $250 billion in assets from most of the rules, other than including unrealized bond losses in their CET1 calculations:
Taken together, the reproposals would increase aggregate common equity tier 1 capital requirements for the G-SIBs, which are the largest and most complex banks, by 9 percent. For other large banks that are not G-SIBs, the impact from the reproposal would mainly result from the inclusion of unrealized gains and losses on their securities in regulatory capital, estimated to be equivalent to a 3 to 4 percent increase in capital requirements over the long run. The remainder of the reproposal would increase capital requirements for non-GSIB firms still subject to the rule by 0.5 percent.
Barr also said he would recommend lowering the initially proposed higher risk weightings for loans secured by residential real estate and loans to retail customers.
This is a win
While capital requirements are still heading higher, I think the industry will certainly take this compromise. Given what happened last year, I think many believed the inclusion of unrealized losses in CET1 ratios makes sense, while the new proposal also removes the suspected damage the rules would have done to consumer loans such as mortgages.
It's also a big win for banks with below and between $100 billion and $250 billion in assets. Banks like Comerica (CMA -1.26%) ($79 billion in assets) and Zions Bancorporation (ZION -1.21%) ($87.6 billion in assets) were stuck between a rock and a hard place, because surpassing $100 billion in assets would have led to significantly higher capital requirements under the BE3 proposal laid out last year.
But the big thing this proposal does for all large banks is provide clarity. Part of the issue with investing in banks is that regulatory capital proposals can change annually, leading banks to prepare for them before they are even passed into law. For instance, most of the large banks have spent the last year refraining from share repurchases and building capital to prepare for BE3 changes.
U.S. Bancorp (USB -1.06%)has repurchased a very minimal number of shares since the second half of 2021. Two days after Barr's speech, the company announced a $5 billion stock repurchase program and said it plans to begin repurchasing in early 2025.
So I think clarity around proposed capital rules makes the group a lot more investable and will get more generalist investors involved.
