A Few Thoughts on Basel III Endgame

Note: this post is part of our series on Basel III Endgame, which features contributions from participants at our Basel III Endgame roundtable. You can find other posts in the series here.

By David Zaring

On November 7, 2023, the Wharton Initiative on Financial Policy and Regulation (WIFPR) convened a number of academics, lawyers, economists, and bankers to discuss the pending proposal by banking regulators on the way to implement the final aspects of the Basel III capital adequacy accord – the internationally agreed upon set of rules that governs the steps banks must take to remain solvent in the event that they invest unwisely, the economy turns on them, or their trading activities go south, among other things.  The conversation was wide ranging, but in this post, I will highlight the fierce opposition of banks to the proposal, the question of how the proposal will affect mid-sized banks, and the international implications of the American approach.

The Response from the Banking Industry: One recurring topic in our discussion of the policy and legal implications of Basel III Endgame was not particularly legal or policy oriented.  It was a concern that the capital rules, which traditionally have been adopted with plenty of informal notice to the industry and a degree of consensus, lacked both input and consensus.  There is no obligation for regulators to obtain the consent of regulated industry, as observers in the workshop noted.  But the bankers and lawyers from the private sector who participated in the workshop conveyed a view that Basel III Endgame was adopted over protest, and that the regulators had failed to take those protests into account.

The result has been an unprecedented degree of pushback to the proposal.  The Bank Policy Institute, a trade association representing large banks, has purchased advertisements decrying Basel III Endgame on social media, podcasts, and even during televised football games.  Congress has held hearings featuring banker witnesses and worried statements about the proposal from Republican and Democratic lawmakers, leading bankers have protested the excesses of Basel III Endgame on the record, and the banking trade associations have hired the kinds of lawyers who bring Administrative Procedure Act cases to fight, and, if necessary, sue over the proposal – a rare development in an industry where banks almost never sue their regulators.  The full court press suggests that the industry feels it has a strong case against the proposal, and that it is willing to press the case, through litigation if need be.

Mid-Sized Banks: Some of the banks most concerned by the Basel IIII Endgame proposal are the mid-sized banks – defined as banks with assets over $100 billion and under $250 billion, who would largely have to comply with the tougher Basel rules with which our largest banks must cope.  The failure, and subsequent bailout, of four mid-sized banks over the course of the spring suggested to some participants that subjecting these large-but-not-enormous banks to tougher capital rules made sense.  Others worried that the proposal would create a “missing middle” in the banking industry, as mid-sized banks would either merge in an effort to reach the scale of our largest banks, given that their regulatory compliance costs would be similar, or shrink below the $100 billion threshold.  Because these banks are particularly active in commercial real estate and small and medium enterprise lending, those parts of the economy might particularly feel the impact of the endgame rules.

International Implications: The American proposal for the adoption of Basel III Endgame is tougher than required by the international agreement. Federal Reserve Chair Jerome Powell noted that the proposal “exceeds what is required by the Basel agreement, and exceeds as well what we know of plans for implementation by other large jurisdictions.” For example, American banks will be unable to use internal models for credit risk; banks in other jurisdictions may still do so. Lending to “investment grade” corporate exposures would only receive the lightest regulatory treatment if the company or its parent must have securities outstanding on a public securities exchange, which have not been part of implementation in the European Union and United Kingdom. And so on.

One problem posed by these American departures is that, whatever the merits of the increased capital requirements, one of the achievements of the Basel Committee has been to level the global playing field. If the Basel III Endgame represents a sharp upward departure from the requirements of the international accord, the value of that level playing field will be lost. The Basel Capital Accords are a remarkable achievement in the history of international regulatory cooperation.  They work through a soft law mechanism that sets complicated bank regulatory requirements at the international level and then implements those requirements when the regulators returned to their domestic jurisdictions. The consequence has been an effective form of international governance — and many more formal international legal systems enjoy far less compliance than does Basel. Some participants in the workshop worried that the upward departure would mean that some of the value of consistent level playing field would be lost. That could undermine both international and industry support for the Basel process, which has served, until now, as a sustainable, long-lasting, and impactful case study for the merits of international cooperation.

David Zaring is Elizabeth F. Putzel Professor of Legal Studies and Business Ethics at Wharton.