Basel III and Bank Capital Rules: A Conversation with Vice Chair Michelle Bowman

Thank you, Michael. Well, thank you very much for the opportunity to join you here at Cato today. I want to thank Michael Norbert for accommodating our schedule on when we were planning to get the timeline for the introduction of these proposals and wanted to provide a preview. So, this is a great opportunity to have a first event of its kind here at Cato, but also to further our opportunity to share some details on our proposal before we have a board meeting to discuss the proposal and move it forward. So, good morning. It's great to be here with you at the Cato Institute as an opportunity to discuss our bank capital requirements. As we all know, capital requirements form the foundation of our prudential regulatory framework. And in the coming week, we will propose rules to implement the final phase of Basel 3 here in the United States. These changes to the capital framework eliminate overlapping requirements. They right-size calibrations to match actual risk and they comprehensively address longstanding gaps in our prudential framework. The result is more efficient regulation and banks that are better positioned to support economic growth while preserving safety and soundness. Following the 2008 financial crisis, regulators implemented reforms that substantially increased bank capital and strengthened the financial system and its resilience. While these initial reforms were necessary, experience shows that requirements that overly calibrate low-risk activities produce unintended consequences. It constrains credit availability. It pushes activity into the less regulated non-bank sector. And it layers on complexity and costs without meaningfully enhancing safety and soundness. Requirements like the global systemically important bank surcharge, the G-SIB surcharge, which has increased in such a way that it has become disassociated from actual risk, illustrate this problem. Continuously increasing capital levels without a specific purpose imposes real economic costs. When capital requirements become excessive, they impair the banking system's fundamental function of providing credit to the real economy. The price is paid in foregone economic growth, reduced job creation, and lower standards of living. In our work to modernize the capital framework, we evaluated changes in the aggregate while taking a bottom-up approach to ensure that the overall framework is appropriate. We did not begin by setting an aggregate target and working backward to meet it. Instead, each requirement is evaluated on its merits, examining first whether it's properly calibrated to risk, second whether it achieves its intended purpose, and third whether it avoids creating unintended outcomes. We have developed these proposals to modify each of the four pillars of our regulatory capital framework for the largest banks: stress testing, the supplementary leverage ratio, the Basel 3 framework for risk-based capital requirements, and the G-SIB surcharge. The Federal Reserve is taking steps to modernize our capital requirements and is working together with the OCC and the FDIC to propose these joint rulemakings. The proposals take into account the aggregate impact of revisions already introduced to the SLR, and we've already introduced the SLR which would restore it to its original role as a backstop to risk-based capital requirements and to the stress test framework. The Federal Reserve has already proposed a number of changes to the stress testing framework and its process to enhance transparency and public accountability. In addition, the outstanding stress testing proposals reduce excessive volatility while providing a robust analysis of bank conditions under a hypothetical stress scenario. The proposals to address the remaining two pillars, Basel 3 and the G-SIB surcharge, streamline the risk-based capital framework using a single set of calculations, improve alignment between requirements and risk, and revise the G-SIB surcharge to better capture the risks of our largest and our most complex banks. We are also updating capital requirements for smaller and less complex banks. So last November, the banking agencies proposed enhancements to the community bank leverage ratio. These revisions reduce regulatory burden and increase flexibility for qualifying community banks while preserving their strong capital levels. A new standardized approach will also revise the risk-based capital requirements for non-G-SIB banks. Together, these proposals will better align requirements with risk and allow banks to engage in lower-risk traditional banking activities. Collectively, they reduce incentives for activities like mortgage origination, mortgage servicing, and lending to businesses to migrate outside of the regulated banking sector. Importantly, the capital framework remains robust. Under the new framework, banks maintain their capacity to absorb losses while continuing to provide credit and financial services to households and businesses across a wide range of economic conditions. So beginning with the Basel 3 proposal, our Basel 3 proposal builds on the 2017 Basel agreement while incorporating targeted adjustments to reflect US-specific aspects of the banking and financial markets. Finalizing these reforms will provide the industry with greater certainty for planning and for management. It will also promote broadly consistent international capital standards. An important feature of this proposal is the elimination of duplicative capital calculations for the largest banks. Today, these banks must maintain two sets of risk-based capital ratios. One using the standardized approach and another using internal model-based advanced approaches. Experience has shown that this duplication creates burden without providing corresponding benefits. Therefore, the proposal establishes a single approach to calculate the risk-based capital requirements for the largest banks to better support the flow of credit to households and businesses. The revised framework improves the risk sensitivity of requirements for lending activities. The proposal recognizes loan-to-value ratios in mortgage capital requirements and reflects repayment history in retail lending. Importantly, it does not add new capital penalties for mortgages or consumer lending and it seeks public feedback on the appropriate role of private mortgage insurance. The proposal also differentiates requirements based on the credit quality of businesses ensuring that capital treatment is aligned with actual risk. Turning to operational risk, the new framework includes standardized requirements for operational risk consistent with international standards but tailored to the US large banks. Activities that produce fee-based revenues and expenses like credit cards would have those revenues and costs accounted for on a net basis rather than separately as in the Basel standard. Staff analysis also indicates that certain activities like wealth management and custody services have historically exhibited lower levels of operational risk and the proposed requirements are calibrated to reflect those differences. On market risk, the proposal also strengthens capital requirements for banks' trading activities in a manner calibrated to unique US capital markets. The methodology better captures losses under stress conditions and it reflects the risk of less liquid positions. It introduces a standardized calculation that applies consistently across firms while reducing burden for banks with simple trading activities. Relative to the Basel standard, the proposal better recognizes diversification across positions and it extends the use of bank internal models where data are sufficiently robust, ensuring capital requirements are commensurate with that risk. On CVA risk, the proposal also introduces a capital requirement for credit valuation adjustment, which is the risk of losses on derivative positions from counterparty credit risk. This requirement applies to banks with significant trading activity and material derivative portfolios consistent with the international standards. Importantly, the requirement focuses on bilateral transactions among large financial firms, avoiding unintended costs for commercial end users of derivatives, including farmers and manufacturers. Stress testing and the resulting stress capital buffer complement the risk-based framework by adding granularity and risk sensitivity. However, overlaps between the stress test and the risk-based framework can produce excessive requirements for some activities. So, in developing the Basel 3 proposal, we were mindful of these overlaps and we evaluated the combined effect of the requirements in our impact analysis. In line with international standards and with a view toward improving risk sensitivity, the Basel 3 proposal increases capital requirements for operational risk and for market risk. Separately, recently proposed changes to stress testing models are expected to improve the reliability of the operational risk model and the coherence of the global market shock scenario. In doing so, it reduces requirements for operational risk and trading positions. The overall calibration of these risks should remain largely unchanged while individual components of the framework are meaningfully improved. I'll turn now to talk about the standardized approach and that proposal. So while we're implementing Basel 3 requirements for large and internationally active banks and it's been long overdue, it is equally important to update risk-based capital requirements for all of our banks. The approach leverages a similar rationale to reduce redundancy, simplify where possible, achieve better calibration of requirements relative to risk, and remove incentives for activities to migrate out of the banking system. The standardized approach proposal modifies risk-based capital calculations for most banks, improving risk alignment while preserving a simple framework. The proposed changes address critical categories of bank lending, including mortgages, consumer lending, and business lending. These changes moderately reduce requirements and align the standardized approach with the Basel 3 proposal. This ensures greater consistency and a level playing field among all banks. The changes better align requirements with risk, increasing efficiency and ensure the availability of credit to households and businesses. At the same time, all US banks would remain subject to robust capital standards. Both the standardized approach and the Basel 3 proposals remove any requirement to deduct mortgage servicing assets from regulatory capital. Instead, they assign a 250% risk weight to these assets while we seek public feedback about what the appropriate risk weight should be. This should reduce disincentives for participating in mortgage markets and servicing their mortgage originations thereby addressing the mortgage activity migration to non-banks over the past 15 years. The standardized approach proposal also requires large banks to include elements of accumulated other comprehensive income or AOCI in common equity tier one capital. This aligns with the treatment of those assets for the largest institutions. The proposal also invites public comment on the appropriate scope of mandatory AOCI recognition and sets a five-year phase-in for this change to avoid a material immediate increase in capital requirements. So I'll now turn to the G-SIB surcharge proposal. Under our current framework, the largest, most complex banks are subject to a G-SIB surcharge, which is a capital requirement intended to mitigate the systemic risk that is posed by these institutions. This proposal strengthens and modernizes this calculation of the requirement in several ways. First, the proposal updates the parameters or the coefficients that determine the impact of firms' activities on the G-SIB surcharge. This better reflects recent changes in the financial system. When the G-SIB surcharge was introduced in 2015, the board committed to regularly review the surcharge coefficients. This practice would have ensured that the coefficients account for changes in price level and for economic growth. But more than 10 years later, the board has yet to complete a review. So over time the surcharges have continued to escalate even when the size of the largest banks has grown roughly in line with the broader economy. In addition, our surcharges have increasingly diverged from the international method for setting the G-SIB surcharge. The proposal addresses this divergence by realigning our surcharge with the international method. And to ensure that the surcharges do not unintentionally increase, the proposal indexes the surcharge to economic growth going forward. These changes keep this additional capital requirement calibrated to the systemic risks of our largest, most complex banks over time. Second, the proposal revises the surcharge component that accounts for risk associated with short-term funding which was originally intended to represent 20% of the surcharge. Instead, it represents 30%. So, revising this element of the surcharge would bring it into better alignment with other elements of the calculation. And third, to reduce incentives to make year-end adjustments to balance sheets, the proposal requires G-SIBs to calculate certain systemic risk indicators as an average of their daily or monthly values rather than at year end. Fourth, to reduce cliff effects and increase sensitivity to changes in a firm's risk profile, the proposal assigns surcharges in increments of 10 basis points rather than 50 basis points. And finally, the proposal improves the measurement of certain systemic indicators, aligning it with international standards. These adjustments reduce capital requirements, but most of the reduction comes from fulfilling the board's commitment to adjust for economic growth and correct excessive requirements associated with the short-term wholesale funding component. We expect the Basel 3 proposal to result in a small increase in requirements for the largest banks similar to what is expected in the UK's proposal. The G-SIB surcharge proposal results in a modest decrease in the surcharges which addresses the recent increases in this requirement that deviated from risk. Together these proposals would decrease the requirements by a small amount. These changes should be viewed as a part of a broad careful review of capital requirements undertaken over the past nine months. We have carefully considered the overlaps between Basel 3 and stress testing to ensure that when combined, capital requirements appropriately capture risk rather than being overly punitive. The resulting cumulative effect on the largest banks' capital requirements is modest. Recent changes to capital rules and accounting standards have significantly increased requirements for large US banks and they are now subject to new and generally higher requirements for potential credit losses and derivative exposures. Stress test losses also increased capital requirements and balance sheet expansion in line with economic growth and inflation has increased G-SIB surcharges. So changes to the G-SIB surcharge based on underlying risk are appropriate, but increases driven mainly by real economic growth and inflation do not reflect increases in systemic risk. In addition, they're contrary to the board's longstanding commitment to update the methodology. Our capital proposals, including the 2025 stress test improvements, maintain capital requirements above the 2019 rules. The cumulative impact serves as a sensible recalibration, reflecting the recent growth of regulatory capital requirements for the largest banks. Smaller banks which are more focused on traditional lending activities will see slightly larger reductions in capital requirements. These changes will maintain resilience and provide flexibility to provide credit to US households and businesses. So in closing, I want to note that crafting these reforms is no easy task and over time there have been many attempts to address some of the individual components of the framework. The proposals that will be published in the coming week will bring us closer to fulfilling the US commitment to implement the 2017 Basel 3 agreement and will complete the first step of our comprehensive review of the capital framework. So we look forward to publishing all of these proposals and to receiving public comments. So thank you. Thanks very much for the opportunity to share our proposal or broad strokes of the proposal with you and I look forward to answering your questions.

Absolutely. Thanks for the opportunity to talk about this. I might just say that we have a number of our staff who worked on the proposals here with us today and I just want to tell them thank you for all the work that you all have done and thank you for being here because I think it's a great milestone and the work that we've accomplished together and over the years that we were able to bring this proposal and its very reasonable approach to fruition. We're looking forward to next week.

It is a bit lengthy.

But it's thorough, I have to say, with actual work of our team.

Why? Because it's so thorough.

Minute details.

Yeah.

Okay. In my humble opinion.

Yes.

Well, as I mentioned, we are looking to, I think we'll be noticing our open board meeting this afternoon. That'll be next week. And then once we have an opportunity to publish the proposal, there'll be a 90-day comment period that's built into the proposal itself. I think it will hopefully be able to implement on a relatively short time frame. I know the rest of the world has worked to accomplish their individual jurisdictions' proposals and they've been waiting for us to get ours off the table. So we're looking forward to ensuring that we can work together to understand what the implementation timeline will be for not just for the US but around the world.

It's more complicated, but we want to make sure that we're meeting this requirement and implementing these requirements on our banks in a time frame that makes sense for the rest of the jurisdictions.

That's correct.

Well, I thank you for mentioning the capital framework day at the Fed that we had last summer. I think that was one way for us to ensure that we understood from industry and from practitioners and academics alike how we should be approaching this project and to ensure that all four of these pillars of the capital framework work together. So as we were approaching our comprehensive review, we needed to make sure we understood how each one of the components would work together to in the aggregate create a reasonable capital framework that continued to address risk in the system, but also to make sure that they were calibrated according to the risks of the activities that are presented to the financial institutions that are conducting them. So as we were building the proposal, we didn't, as I mentioned in my remarks, we did not start from a particular level of capital. We were looking at each one of the activities on its own and to understand what the appropriate level of risk weighting should be for each of those activities. So, as we've been working on the stress test proposal and finalizing, working to finalize that, which we expect to be done hopefully before the end of the year, well before the end of the year, the SLR, as you mentioned, was finalized last fall. So, we know what those impacts likely will be and then they could feed into the other work that we're doing with the broader Basel 3 proposal and then also with the G-SIB surcharge. So our hope is that with this introduction of the proposal, we'll have a very clear understanding of what capital requirements will be for the banking system as a whole. And I also mentioned that we implemented together with the other agencies. And I want to just recognize the incredible willingness of all three of our agencies with Jonathan Gould and Travis Hill over at the OCC and FDIC and all of our staffs have worked so closely together on a very tight timeline to move forward with the interagency proposals and you know I think we're all very proud of the work that we've accomplished there. But our hope is that this will be a very clear, straightforward, as straightforward as these complex capital proposals can be, but in a very approachable way that is clear what the impacts will be.

So it's been a series of different proposals because there are different phases that have to be implemented. So we're currently in the process of, we've announced that we froze the SCBs at last year's levels as we're trying to finalize the model changes for this year's stress test so that we're not using flawed models to implement capital requirements which are really important to get right.

Absolutely. Well, it's really important that all of these components work together. So especially important is Basel 3 and the stress test requirements. So as we were building through the process for finalizing the changes to the stress test framework that we've been working on since last year, we wanted to make sure that we understood how they would interact and we would no longer have overlapping or duplicative requirements. So now that we've had the opportunity to review them all in the aggregate, it was important to understand how these two proposals in particular would work together. And so we believe that we've resolved any conflicts there, but we look forward to comments. Obviously, we're very close to it. So we want to make sure we understand the industry's views and academics' views of all of our stakeholders on what they'll be reviewing in the coming week. I'm sure there'll be lots of opinions.

And that is how that process is supposed to work. So that's a good thing.

Well, we think it's a good thing. I think it's definitely a different approach.

Well, let's start with what you just said, which is that these effects or the effects of our capital calibrations have real impacts on the economy. And I think that's the most important thing that I had in mind as we were approaching this project is recognizing that each one of the calibrations impacts the ability of different parts of our economy to function and function efficiently and effectively. So in particular, I was a banker as we were implementing Dodd-Frank and especially the mortgage rules and what we found and over time as we've done more research is that at one time 60% of mortgage originations happened within the banking system. Now that's 35%. The rest of that activity occurs outside of the regulated banking system. When we look at the statistics for mortgage origination, for servicing those originated mortgages, it used to be that banks serviced 95% of those on their, or held them on their balance sheets. Now we have 45% of that activity on banks' balance sheets. These are traditional relationship-based activities that originated, started in the banking system. It makes sense that we would encourage banks to return to some of those activities. I think as we were looking at the number of activities and we all think about this in the NBFI space and as we're trying to understand the activities and why there's been such growth in that sector of the financial system, a lot of the activity that used to occur within the regulated banking space has been pushed out based on regulatory preferences or directionally with calibrations of activities outside of that space. And this proposal will work to reverse some of that trend and allow for better risk weighting of those activities to bring it back in. In particular, mortgages is one of those areas. And I think as we were looking at more broadly, having been a community banker, those are the foundational activities that community banks offer that they're based on relationships. They understand the people that they're lending to. They can work with them if they experience economic hardship or lose a job. It's a different relationship than it is to have a very distant servicer. So I think that this is one of the motivations for some of the approaches that we've taken in these capital proposals is that we really want to tie these activities to banks supporting the economy and to their consumers and to their businesses and directly to the regions that they serve.

Absolutely. And the US economy, right? Supporting economic activity.