October 14, 2024

By Keegan Ferguson, Capstone Financial Services Analyst

The tortured history of the Basel III Endgame proposal— rules that aim to strengthen bank regulation, supervision, and risk management—took another turn in recent weeks when Bloomberg and others reported that the apparent deal to overhaul the original July 2023 proposed rules was being held up due to an internal disagreement within leadership at the Federal Deposit Insurance Corporation (FDIC). Rohit Chopra, Consumer Financial Protection Bureau (CFPB) director and FDIC board member, reportedly is displeased by the extent to which the original rules proposal has been watered down, and he is blocking a partial re-proposal of the rules. Republican FDIC board members Travis Hill and Jonathan McKernan have indicated that they will not vote affirmatively for the overhaul, preferring a full withdrawal and re-proposal of the Basel III Endgame rules. Capstone believes Chopra’s intransigence may appease progressives for now. Still, a failure to move forward with a partial re-proposal before the November election could lead to a set of Basel III rules that fall far short of progressive preferences.

A failure to move forward with a partial re-proposal before the November election could lead to a set of Basel III rules that fall far short of progressive preferences.

The Basel III Endgame proposal immediately drew intense opposition from the banking industry. The original proposal—which had long been in development but seemingly sought to respond to the collapse of several large regional banks in the spring of 2023—promised to flatten the regulatory framework for large banks. It applied nearly the same set of capital requirements proposed for the largest, globally systemically important banks (G-SIBs) to large regional banks as well. All told the original proposal was estimated to increase the amount of risk-weighted assets that covered banks would have to hold to meet their required capital ratios by ~20%. While the industry voiced significant opposition to the proposal, a handful of non-traditional bank allies also pushed back against targeted elements of the rules. In particular, risk-weighting changes for housing and tax equity exposures drew the ire of progressive housing and clean energy groups that argued that the new capital requirements would reduce banking financing for low-income home buyers and new green energy projects.

Changes to the original proposal were heavily telegraphed in speeches by regulators and reporting over the last several months. Then, in September, at a Brookings Institution event, Federal Reserve Vice Chair for Supervision Michael Barr unveiled a set of proposed changes to the Basel III proposal. The announced changes, which regulators at the Office of the Comptroller of the Currency (OCC) and FDIC apparently agreed to, significantly softened the original Basel III proposal. Broadly, the tailoring framework for large banks, according to Barr, would be maintained, and only G-SIBs (and other banks with significant trading activities) would be subject to the most punitive elements of the revised Basel rules. Smaller regional banks, those with $100 billion to $250 billion in assets, would be largely exempt from the new rules, except for new requirements to include unrealized gains and losses on the available-for-sale securities portfolios in regulatory capital. Under the apparent Basel revisions, the G-SIBs would see about a 9% increase in Common Equity Tier 1 capital requirements, while smaller institutions would see a 3.5% to 4.5% increase. At the time of the announcement, Capstone expected federal banking regulators to move forward with the partial re-proposal within days or weeks.

However, we are more than a month removed from Barr’s Brookings appearance and there has been no public movement on the partial re-proposal. Chopra reportedly is blocking forward movement at the FDIC. Capstone believes his opposition could undermine his goal of higher capital requirements and result in an even lighter set of Basel III reforms.

We believe there are three likely scenarios with the Basel III rules moving forward:

• Scenario 1: Partial Re-Proposal: Regulators could move forward with the current compromise and seek an almost 9% capital increase. Following a new comment period, some elements of the proposal will likely be softened further, but most of the market-risk reforms aimed at curbing risky trading activities at large banks will likely survive. The banking industry might push back, but the threat of litigation is likely mitigated, given the softening of the rules. While a Trump election victory could create some pushback from new leadership at the OCC and FDIC, we expect that Fed Chair Jerome Powell’s support for the new rule and the inertia created by the re-proposal would carry the day, and the rules would be finalized. In this instance, neither progressives nor conservatives would be thrilled with the resulting regulatory capital calibration, but a Basel III Endgame rule would be finalized sometime in 2025
• Scenario 2: No Basel III Vote Until After the Election; Trump Victory: If regulators stall on moving forward with a proposal until after the election and Trump is elected, there will be significant leadership turnover at the OCC and FDIC. Without an in-flight partial re-proposal, we believe the leverage of new FDIC and OCC leadership to call for full Basel III withdrawal increases. For progressives such as Chopra, we believe this meaningfully increases the likelihood of a finalized Basel III proposal that falls far short of even the more modest capital increases that Barr floated last month.
• Scenario 3: No Basel III Vote Until After the Election; Harris Victory: If the proposal remains stalled until after a Harris election victory, more progressive leadership will remain in place at the OCC and FDIC. Capstone still believes, however, that ratcheting up the capital increase for large banks, relative to the re-proposal that Barr put forth, would be difficult. First, Powell and Barr apparently have already agreed to a more modest proposal as have other Democratic leaders at the FDIC and OCC. Second, a more aggressive proposal promises to increase the threat of litigation from the industry, particularly in the wake of the US Supreme Court’s Loper Bright decision earlier this year, which limits the authority of federal agencies.

We think Chopra is meaningfully increasing the likelihood that the Basel proposal will be fully withdrawn after a Trump election victory and significantly watered down and eventually re-proposed.

While we can squint our eyes and see a scenario where a Harris victory gives Chopra some additional leverage to push back against the weakened proposal, the best deal that Chopra is likely to get is already on the table.  Given the support at the Fed and from other Democratic members of the FDIC, we believe Barr’s revised rules are likely the new anchor point for renewed negotiations as capital requirements aren’t likely to be moved higher. Moreover, the stability of Fed leadership creates additional leverage for them to hold pat at a 9% increase. Key leaders on the board, who by all accounts have led the redesign effort, are unlikely to change until 2026, while Chopra’s fate, even under a Harris victory, is less certain. By blocking the partial re-proposal, we think Chopra is meaningfully increasing the likelihood that the Basel proposal will be fully withdrawn after a Trump election victory and significantly watered down and eventually re-proposed. In any case, the opposition from commenters and regulatory infighting have delayed the implementation of the Basel rules by at least a year beyond the original proposal, giving the industry a much longer runway to prepare for whatever eventual changes are required.

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