Factbox: How Regulators Have Overhauled Contentious Basel Endgame Capital Hike Rule

By Hannah Lang

The Federal Reserve’s regulatory leader recently announced significant revisions to the Basel Endgame draft rule regarding bank capital requirements, following considerable opposition from the banking industry. The revised proposal is expected to be published by the Fed in the coming weeks and will require approval from the central bank’s board. Here are the key changes being implemented:

CREDIT RISK

Capital requirements for credit risk are designed to safeguard against potential losses from unpaid loans. Fed Vice Chair for Supervision Michael Barr indicated that the updated draft proposes to reduce risk weights on residential real estate loans and loans to retail customers. The initial draft took a more risk-sensitive stance on these loans, but lenders contended that it exaggerated their risks, potentially impacting home affordability and ownership.

Another significant change involves extending reduced risk weights to low-risk corporate exposures for some privately held investment-grade entities. Previously, this preferential treatment was granted only to publicly traded firms. The revised approach will now include pension funds and certain mutual funds in this category.

Additionally, the proposal will eliminate a minimum haircut requirement for securities financing transactions, a move pushed back against by Wall Street banks. This adjustment aligns with international treatment of such assets.

EQUITY EXPOSURES

Barr also announced plans to substantially decrease the risk weight assigned to tax credit equity funding structures, which pose lower inherent risks compared to other equity investments. This adjustment aligns with existing Fed policies on other tax credit investments, such as low-income housing tax credits.

OPERATIONAL RISK

A critical aspect of the Basel framework is enhancing the measurement and capitalization of losses linked to operational risks, which include issues such as fraud and cyberattacks. The initial draft proposed adjusting capital charges based on a bank’s operational loss history, but this has been abandoned in order to stabilize capital requirements.

Under the new plan, the operational risk assessment will adjust how banks’ fee-based income is measured, switching from gross revenues to net income. This shift aims to provide a more consistent evaluation of operational risks across various banking activities and reduce sensitivity to differing accounting practices. Furthermore, operational risk capital requirements for investment management activities will be lowered, reflecting the historically low operational losses in comparison to income from such activities.

MARKET RISK AND DERIVATIVES

The revised draft will ease restrictions on banks’ use of internal models for evaluating the risks associated with trading and derivatives activities. The Fed will also amend capital treatment for certain client derivatives that are cleared, better reflecting the inherent risks of those transactions.

TIERING

The new regulations will enforce the strictest requirements on global systemically important banks (GSIBs) and other major international banks. Nonetheless, the capital requirements for large non-GSIBs will be simplified. Banks with assets ranging from $250 billion to $700 billion that are not classified as GSIBs or internationally active will need to adhere only to credit risk and operational risk requirements, while only those engaging significantly in trading activities will be subject to market risk and related frameworks.

For these banks, along with midsize institutions with assets between $100 billion and $250 billion, the current capital definition will be applied, with adjustments to account for unrealized gains and losses on specific securities. This change aims to better integrate interest rate risks into capital requirements, an issue that significantly contributed to recent bank failures.

In summary, the modifications proposed by the Fed reflect a response to industry concerns while maintaining the intent of bolstering the stability of the banking system.