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 Sarah Hammer
The endgame is here. The denouement of Basel III arrives over a decade since its introduction, signifying a pivotal moment in global banking regulation. Intended to address deficiencies in financial regulation that led to the Great Financial Crisis of 2007-2008, the Third Basel Accord of 2010 proposed a sweeping set of capital and liquidity regulatory requirements across the financial sector. In 2017, the Basel Committee on Banking Supervision agreed to amend those international standards, and in 2023, U.S. banking regulators set forth a notice of proposed rulemaking (NPR) that would modify how the largest U.S. banks implement regulatory capital.
While it is not within the scope of this post to address all of the components of Basel III Endgame, suffice to say they are significant. First, it entails an overhaul of the existing market risk framework, requiring a standardized approach and internal model approach with regulatory approval. Second, the recalibration involves an expanded risk-based approach that replaces the advanced approaches, thereby eliminating use of internal models for credit and operational risk calculations. Furthermore, a new standardized operational risk framework is outlined, scaling up capital based on historical losses. Additionally, the proposal concurrently implements a 20% increase in risk weights for residential real estate mortgages. The proposal also mandates recognition of unrealized gains and losses on available-for-sale securities in capital for all banks with more than $100 billion in assets. It furthermore imposes higher capital charges for deviations from international standards, and revises G-SIB scores based on averages versus points in time, likely resulting in higher scores and potentially higher surcharges. All in, some estimate the proposed rule would increase capital requirements by 20-25% for the largest banks.
In evaluating these sweeping proposals, I strongly support the principle of ensuring banks are resilient during a crisis. Unquestionably, strong banks are essential to the competitiveness and economic growth of the United States. Not only are banks critical to the success of American industry and capital markets, but they are also important to small business and households. This in mind, we must acknowledge that augmenting capital and liquidity regulation, on its own, will not address the multifaceted challenges encountered by today’s banks. A highly focused and disciplined approach is imperative to fortify liquidity management and navigate through potential modern-day bank run catalysts. We must also acknowledge that adding more capital and liquidity requirements without precise and robust analysis and implementation may actually harm banks’ ability to deploy capital and liquidity in times when it is most needed, as well as exacerbate challenges in vital areas such as the treasury market liquidity.
In light of this, I recommend we turn our attention to the fundamentals of banking: the management of interest rate risk and liquidity risk across a bank’s balance sheet. These are basic, but important, foundational principles to understand the duration and stability of a bank’s deposits, and the duration and liquidity of a bank’s assets to support them.
Surely, the March 2023 bank failures demonstrated the unprecedented urgency and destruction of modern bank run catalysts. The failures emerged due to a confluence of factors, including mismanagement of basic interest rate risk and liquidity risk by several regional banks. Communications on social media escalated fears of financial instability, and investors and depositors hastily withdrew their funds, made easier by digitization, exacerbating the collapse of banks almost overnight.
It is worth noting three commonalities among the regional banks that experienced distress last March. First, all were below the $250 billion threshold for systemically important designation. Second, while all employed different business models, they also all had a concentrated deposit base and client base heavily weighted in technology, crypto, venture capital, and/or high net worth clients. In today’s technology-focused economy, policymakers should acknowledge that these types of clients are increasingly prevalent. The third commonality was that none had sufficiently robust liquidity risk management to anticipate or address the situation.
Thus, I advocate for a new and more sophisticated approach. Within this, it is clear that merely requiring banks to hold more capital would not have substituted for the type of liquidity risk management that is necessary to stave off the unprecedented speed of an SVB-type bank run. Instead, it is crucial that banks practice sound asset-liability management and have a diversified range of liquidity options that they can access under adverse conditions.
The current regulatory measures for liquidity, the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR), were set forth with careful consideration. For context, the LCR is intended to enhance banks’ short-term resilience and requires unencumbered high quality liquid assets equal to net total outflows over a 30-day stress period, with categorization of assets as Level 1, 2A, and 2B (ranging from more to less liquid). The NSFR is intended to promote resilience over a longer time horizon by requiring the ratio of available stable funding (ASF) to the required stable funding (RSF) over a one year period to be equal or greater than 100%. This is intended to create incentives for banks to fund their activities with more stable sources of funding and have sufficiently liquid assets on hand to meet those obligations on an ongoing basis. While these frameworks are foundational, they were initiated years ago, before the rapid proliferation of aforementioned digitized banking and social media.
While not a panacea, new and more robust liquidity risk management is what is needed to meet the challenges of modern-day bank runs. I advocate for development of additional robust measures within existing authorities that leverage current and new technologies and data management techniques for evaluation purposes. An example of this would be to employ applied machine learning to the financial sector’s rich data environments and develop more accurate measures for hourly, daily, and weekly liquidity, across multiple key asset classes. With today’s modern technology, we have the capability to optimize not only liquidity risk management, but also deployment of capital. Using these technologies, we could adjust regulation to fit the needs of modern liquidity challenges. These technologies could also be combined with improvements to operational processes necessary to tap liquidity facilities in times of distress. Application of such technologies can also potentially better enable cost benefit analysis, which, while difficult, enhances the regulatory decision-making process.
Finally, and more generally, I recommend a holistic view of the banking and financial ecosystem, with consideration given to the importance of a healthy banking ecosystem comprised of not only large banks, but also medium and small sized banks. This banking ecosystem does not exist within a vacuum, but rather sits within a global financial ecosystem that also includes non-banks and financial market infrastructure providers (such as central clearing counterparties), both inside and outside the United States. Such a view requires awareness of the application of Basel III to regions such as Europe and the UK, where capital and leverage requirements (and their bindingness) may differ. The competitive dynamics of the global financial landscape require a nuanced approach that implements regulatory stringency while fostering a resilient and economically strong financial ecosystem across jurisdictions and sectors.
Sarah Hammer is Executive Director at the Wharton School and Adjunct Professor of Law at the University ofPennsylvania Law School. She was previously Acting Deputy Assistant Secretary for Financial Institutions at the United States Department of the Treasury and Acting Secretary of Banking and Securities for Pennsylvania.