Rethinking Banking Regulation and the 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 Tomasz Piskorski


The 2023 bank failures underscore the fundamental issue of banking vulnerability rooted in the extensive financial leverage employed by banks and their susceptibility to solvency runs. The ongoing “Basel III endgame” aims to address this by proposing increased capital requirements for the largest banks in the US. The CEOs of these top banks have criticized the proposal, expressing concerns that the proposed “Basel III endgame” rule would unjustifiably and unnecessarily increase capital requirements for the largest banks and that such increase can have adverse effects on aggregate lending and the broader economy.

Our research suggests three key implications for the current “Basel III endgame” proposal. First, our work indicates that currently on average banks’ capital is about 25% lower than it would have been in the absence of safety nets embedded in insured deposit funding. This suggests the scope for increased capital requirements. However, if anything, these are smaller and mid-size banks that are much more financially leveraged than they would have been due to their access to insured deposit funding. These institutions are also currently more exposed to insolvency risks, and hence regulators could consider prioritizing an increase in capital requirements for smaller and mid-size banks.

Second, our work suggests that the overall impact of raising capital requirements on aggregate lending may not be as substantial as commonly stated. This is due to the diminishing importance of bank balance sheets in lending, given banks’ ability to sell their loans in various market segments and the potential migration of certain lending activities to non-banking institutions.

Third, regulators could adopt our methodology of assessing the Uninsured Depositor Run Risk (UDRR) ratio, a new empirical measure of bank fragility we developed. This would enable them to conduct stress tests on the banking system to assess the potential for solvency runs by uninsured depositors in response to interest rate and credit shocks.

The Fundamental Bank Vulnerability: High Financial Leverage and Risk of Solvency Runs

The root cause of banking vulnerability lies in the extensive financial leverage employed by banks. A typical US bank finances approximately 90% of its assets through debt, mainly in the form of deposits. This heightened financial leverage makes banks highly susceptible to shocks, such as higher interest rates or adverse credit events, negatively impacting the value of their assets. With a typical leverage of a US bank, even a 10% decline in bank asset value can potentially lead to insolvency.

The recent monetary tightening has again highlighted this vulnerability. Banks engage in maturity transformation: they finance long maturity assets with short-term liabilities—deposits, and hence an increase in interest rates can adversely affect their asset values. As I show in my work with Erica Jiang, Gregor Matvos, and Amit Seru following recent rise in interest rates the U.S. banking system’s market value of assets is more than $2 trillion lower than suggested by their book value accounting for loan portfolios held to maturity. Given high leverage of banks this decline in bank assets’ value is in the order of pre-existing aggregate value of bank equity. Consequently, about half of U.S. banks (2,315) with $11 trillion of assets have a lower value of their assets compared to the face value of their debt liabilities.

This does not mean that half of U.S. banks are insolvent. Banks primarily fund themselves with deposits so they could survive these asset value declines if they can pay low rates on their deposits and their depositors do not flee. However, about half of deposits are uninsured, accounting for about $9 trillion of bank funding in the aggregate. Unlike insured depositors, uninsured depositors stand to lose a part of their deposits if the bank fails, potentially giving them incentives to withdraw their funds in response to the decline in bank assets values.

With Jiang, Matvos, and Seru we present a model of solvency runs, which illustrates that interest rate increases can lead to self-fulfilling solvency bank runs even when banks’ assets are fully liquid. The model identifies banks with asset losses, low capital, and critically, high uninsured leverage as being most fragile. We develop a new empirical measure of bank fragility, the Uninsured Depositor Run Risk (UDRR), that identifies the bank as insolvent if the mark-to-market value of their remaining assets after a given withdrawal by uninsured depositors would be insufficient to repay all insured deposits. Our calculations suggests that potentially hundreds of US banks are at a risk of such insolvency depending on the share of uninsured depositors that decide to withdraw their funds.

Additionally, in a related work we demonstrate that the substantial decrease in banks’ asset values due to rising interest rates has weakened their capacity to weather adverse credit events, especially focusing on commercial real estate (CRE) loans, which constitute about a quarter of assets for an average bank. Factoring in potential distress in CRE loans, dozens of additional U.S. banks could face such insolvency risks.

Implications for Bank Regulation

Short-Term Response: Bank Recapitalization

In the near term, measures like the creation of the Bank Term Funding Program in March 2023 and potential blanket guarantees for uninsured deposits have mitigated the crisis and reduced the risk of acute deposit runs. However, these policies, primarily addressing liquidity shortages, do not tackle the fundamental bank insolvency risk. Therefore, in the short term, we propose a market-based recapitalization of the U.S. banking system.

Longer-Term Response

Rising Bank Capital Requirements

In the longer term, banks may face more stringent capital requirements, aiming to enhance the resilience of the U.S. banking system against adverse shocks to their asset values. The critical consideration, however, is determining the financial leverage required for the efficient provision of banking services.

I explore this question with Jiang, Matvos, and Seru, by comparing the financial leverage of banks with non-banks engaged in similar lending activities. Non-banks operate under a less restrictive regulatory framework but lack access to insured deposit funding. Our findings reveal that non-banks maintain more than twice as high capital buffers than banks, with the most significant disparity observed among smaller and mid-size banks that exhibit much higher financial leverage compared to their unregulated counterparts without access to deposit funding. Notably, the primary factor contributing to the high leverage of large banks is their capacity to generate money-like deposits, while for smaller and mid-size banks, their reliance on safety nets provided by insured deposit funding also plays an important role. These findings suggest the potential for substantial increases in bank capital requirements, particularly for smaller and mid-size banks.

A natural question arises: What would be the effects of such an increase in capital requirements? My work with Greg Buchak, Gregor Matvos, and Amit Seru indicates that addressing this question necessitates considering the industrial organization of the financial intermediation sector. This includes accounting for the equilibrium interaction between banks and non-banks and the fact that banks nowadays are selling a significant share of the loans they originate. For example, following the increased regulatory measures imposed on banks post the Great Recession, we found that there was a reduction in bank lending, but a substantial portion of that lending migrated to shadow banks. This migration played a moderating role, mitigating the adverse impact of bank regulation on aggregate lending volume.

In this regard, our work demonstrates that raising capital requirements on banks would have modest effects on aggregate lending, particularly in market segments where selling loans, such as conforming mortgages, is straightforward. As capital requirements increase, banks tend to sell a larger share of their loans rather than retaining them on the balance sheet, which becomes costlier. Some of the bank lending activity also shifts to shadow banks. Furthermore, increasing capital requirements on smaller and mid-size banks is likely to have modest aggregate consequences due to reallocation of lending activity from smaller banks to larger banks and shadow banks, which can achieve significant lending with substantially smaller leverage.

It is important to acknowledge that such reallocation activity do not imply an absence of potential adverse effects of raising capital requirements. In market segments where selling loans is challenging and where smaller and mid-size banks play a vital role, there could be significant redistribution consequences, with certain consumers disproportionately bearing the burden of tighter capital requirements. Moreover, the migration of lending activity to non-banks raises questions about financial stability, necessitating further investigation.

Uninsured Depositor Run Risk Stress-Testing and Risk Management Oversight

Beyond recapitalization and increased capital requirements, other regulatory responses could involve heightened oversight of the U.S. banking system. Regulators could adopt our methodology of computing the UDRR ratio, a new empirical measure of bank fragility we developed. This would enable them to conduct stress tests on the banking system to assess the potential for solvency runs by uninsured depositors in response to interest rate and credit shocks.

Regulators could consider more complex banking regulations on how banks account for mark-to-market losses and manage their interest rate and credit risk. In this regard, we document that banks have not hedged most of their interest rate exposure with derivate instruments leavening them quite exposed to rising interest rate risk. However, addressing these issues consistently, given the multitude of regulators with overlapping jurisdictions, may pose challenges.

Tomasz Piskorski is the Edward S. Gordon Professor of Real Estate in the Finance Division at Columbia Business School and a Research Associate at the National Bureau of Economic Research.