Basel III Endgame was inevitable for large banks, but what about non-banks and smaller banks?

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 Viral V Acharya

“Basel III Endgame” is a set of rules proposed by the US regulatory authorities, applicable to banking organizations with more than $100 billion in assets, in order to make bank capital adequacy requirements more consistent with the international capital standards issued by the Basel Committee on Banking Supervision. The rules are aimed at making risk-weighted assets of banks more transparently and consistently risk-based for credit risk, switching from “value at risk” to “expected shortfall” for market risk, and introducing standardized approaches for capital adequacy against operational and counterpart risks (as against leaving them entirely to the discretion of bank management). Public comments on the proposed rules have now been received by the authorities. The plan is that a revised set of final rules will be implemented in a 3-year phase starting on July 1, 2025.

Since the proposed rules will likely raise capital requirements, all else remaining equal, for the largest bank holding companies – including the global systemically important banks (G-SIBs) – of the US, there is unsurprisingly resistance among the largest banks to the Basel III endgame. However, the rules were in some sense inevitably going to be implemented in the US given they are part of the global standard that the US banks had not yet fully adopted. There is also good economic rationale behind most of the proposals. Internal risk-weight models are known to be manipulated by banks, especially by under-capitalized ones and when the cost of capital is high, so that some standardization of risk-weights to put a “floor” on the manipulated capital requirement of a bank is desirable. It is better to focus on expected shortfall rather than value-at-risk in assessing trading book risks as the former is more robust to varying assumptions of risk distributions that move around probability mass in the tails. Furthermore, in the recent banking stress that started in March of 2023, better capital (and liquidity) position of large banks has been a source of their strength, allowing them to attract flight-to-quality deposits. Given these considerations, even if the rules are ultimately diluted some, they are likely to be helpful in maintaining financial stability of the largest US bank holding companies.

Of course, all else is unlikely to remain equal when Basel III endgame rules are implemented. When capital requirements on banks are raised for a specific set of risks, intense regulatory arbitrage activity takes hold of the financial sector. Bank risks get transformed into newer forms that are then spread between banks and non-bank financial institutions (NBFIs) so that overall capital requirement for these risks is reduced for the sector as a whole relative to the capital requirement if risks were retained by banks on their balance sheets. This does not, however, make banks less profitable. Banks continue to take risk exposures to NBFIs indirectly and offer them funding and liquidity services for a fee.

In particular, as explained in my recent work with Nicola Cetorelli and Bruce Tuckman (“Where Do Banks End and NBFIs Begin?”), NBFIs remain highly dependent on banks when, and even after, such transformation of bank risks occurs. For instance, banks continue to hold tranches of collateralized loan obligations (CLOs) that finance leveraged loans to sub-investment-grade borrowers, purchase mortgage-backed securities after originating and securitizing mortgages, make loans and provide standby letters of credit that are used for originations by private credit funds and private equity companies, and insure liquidity risks of real estate investment trusts (REITs) via bank credit lines that are drawn down in both normal times and under stress.

An important challenge, therefore, for regulation post Basel III endgame isn’t that banks won’t remain profitable or that some intermediation activity will altogether collapse, but instead that the financial sector will organically evolve to keep system-wide leverage higher than intended. In doing so, the sector will create bank-NBFI linkages that regulation should be aware and take account of, for micro-prudential and especially macro-prudential or systemic-risk considerations.

A bigger challenge for regulation at present, however, concerns the health of smaller, non-GSIB banks in the US. These are mostly omitted from the implementation of Basel III endgame rules. Following the interest-rate hikes of 2022-23, many of these banks are severely under-capitalized due to (partly unrecognized) losses on their securities investments, notably in Treasuries and mortgage-backed securities. While their insured deposits may be a valuable franchise whose sticky deposit rates hedge them against these losses, smaller banks’ uninsured demandable deposits have grown significantly since 2007-08. My work with Rahul Chauhan, Raghuram Rajan and Sascha Steffen (“Liquidity Dependence and the Waxing and Waning of Central Bank Balance Sheets”) documents that for US banks below $50 billion in assets, uninsured demandable deposits have doubled in size both relative to assets as well as relative to potential liquidity calculated as the stock of reserves and Fed-eligible securities. As witnessed during the failures in March-April 2023 of Silicon Valley Bank, Signature Bank and First Republic Bank, uninsured deposits can be flighty and run swiftly on banks whose solvency is a question mark.

On the surface, the banking system has stabilized since measures of March and April 2023 to backstop uninsured depositors and provide generous lending-of-last-resort to banks against their eligible collateral at the central bank. However, such liquidity support recently expired and unless bank solvency is restored, regional and smaller banks will remain vulnerable to the risk of uninsured deposit runs in the future. Interest rates are likely to remain high given the last-mile stubbornness of inflation in normalizing to target levels. Since the resulting interest rate risk has not yet been fully marked to market on the balance sheet of many banks, they have not used the relative calm of recent months to rebuild capital position via equity issuances or asset (including whole-bank) sales. Lurking in the background is also the ongoing repricing of commercial real estate (CRE) which is experiencing a structural shift post-COVID in office and mall space. The CRE loan losses, to which small banks are most exposed, are also inadequately marked.

Net-net then, small banks are the second set of entities besides the NBFIs on which the regulatory authorities need to focus soon after the endgame rules are finalized. These banks are at risk of both insolvency and illiquidity, which tend to feed on each other, giving rise to system-wide runs and adverse spillovers to the real economy. When underlying risks are common to the banking system – as high interest rates and CRE losses are – a standard recipe is to first do an earnest asset quality review (AQR) to mark the books properly and then be ready for dealing with recapitalization of insolvent or at-risk banks, either via mergers-and-acquisitions involving better-capitalized banks or via injections of public capital (for more details, see Chapter 6 of NYU Stern’s book “SVB and Beyond: The Banking Stress of 2023”). Liquidity coverage ratio, presently applicable only to the larger banking organizations, may also have to be applied to smaller banks to reduce their growing reliance on uninsured demandable deposits.

Basel III endgame should not be the regulatory endgame in the US efforts to maintain financial stability.

Viral V Acharya is the C. V. Starr Professor of Economics at New York University Stern School of Business.