Capital requirements are a cornerstone of the prudential regulatory framework. The Basel Endgame package will bring substantial changes to the US capital markets. These changes are expected to significantly increase banks’ capital requirements over-and-above their historically high levels. Higher capital levels have benefits (i.e., reduce the likelihood of a bank failure) but also costs (i.e., they limit banks’ ability to support capital markets and the broader economy, and make it harder and more expensive for businesses, consumers, and investors to obtain financing).
Given policymakers chosen by both Republican and Democratic administrations have stated for some time that the current banks’ capital levels are strong and robust, Federal Banking Agencies (Office of the Comptroller of the Currency, the Board of Governors of the Federal Reserve System, and the Federal Deposit Insurance Corporation, collectively “agencies”) should carefully weigh the costs and benefits of implementing the Basel Endgame package and should be transparent about the rationale for further increasing capital levels.
Internal vs. standardized models
To ensure the robustness and adequacy of banks’ internal models, the agencies issued the Guidance on Model Risk Management (SR 11-7) in 2011. The European Central Bank (ECB) embarked a Targeted Review of Internal Models (TRIM) at the beginning of 2016, and issued the ECB Guide to Internal Models in 2019. The EU’s CRR3 proposal and the UK’s Basel 3.1 standards continue to allow the use of the internal models to set capital requirements.
However, the agencies have indicated that they are now intent on “replacing the Advanced Approaches with risk-based capital requirements based on the revised Basel standardized approaches for credit risk and operational risk”. As a result, the agencies will rely largely on the revised Basel standardized approaches to set the risk-based capital requirements.
Such an outcome would disincentivize banks from enhancing and building expertise in the internal models which facilitate more accurate risk measurement and management overall, whereas “the standardized approaches [are] too crude and unrealistic to be useful tools for measuring and managing capital consumption and risk.”
This move away from internal models will not only lead to capital increases at the firm-wide level, but will affect how capital is allocated internally within firms, placing constraints on certain business lines more than others. The market’s experience with the Standardized Approach to Counterparty Credit Risk (SA-CCR) rule, which came into effect on January 1, 2022, provides a good real-world example of these sorts of impacts.