Fact check: Debunking seven key misconceptions in the Basel III proposal

By Hu Benton and Hugh Carney
ABA Viewpoint

Federal Reserve Vice Chairman for Supervision Michael Barr spoke recently at ABA’s Annual Convention, where he outlined his case for key aspects of the Fed’s “Basel III endgame” proposal and attempted to explain why he believes the rule’s benefits would outweigh its significant costs. Unfortunately, his remarks further perpetuated many misconceptions about how the rule would impact banks of all sizes and the broader economy.

The proposal would impose unnecessary new capital requirements that would limit credit availability and threaten our economic growth and resiliency at a critical time. In fact, as regulators have repeatedly affirmed and recent stress tests have demonstrated, the U.S. banking system is already well capitalized, and regulators have not demonstrated how the proposal would increase safety and soundness. ABA continues to vigorously oppose the U.S. regulators’ position on the Basel III endgame, and below, we fact-check some of the most dangerous misconceptions that Barr and other regulators have put forward in attempting to justify the rule:

1 Misconception: The Basel III endgame is a necessary reform following the 2007-08 global financial crisis.

Fact: The Basel III endgame fails to consider 15 years of regulatory reforms and is solving a problem that no longer exists.

Basel III was initially conceived in response to the 2007-2008 global financial crisis, aiming to enhance the stability and resilience of the banking sector. However, the financial and regulatory landscape has evolved substantially since then. Over the 15 years since the global financial crisis, significant regulatory reforms and changes have been implemented globally to enhance banking resilience, risk management and market stability. Besides strengthening capital and liquidity, banks now regularly stress test their balance sheets and operations, employ rigorous risk governance policies and procedures and update resolution plans to reduce the impact of a failure on financial stability. Regulatory bodies should acknowledge the substantial progress made during this period and the substantial supervisory tools at their disposal and build upon these advancements rather than enforcing additional and potentially redundant regulations. Today’s efforts add layers to a dated regulatory reaction to a situation that no longer obtains. Any capital framework revisions should reflect the current health of the banking industry today, not its state pre-2008.

2 Misconception: Banks need higher capital levels.

Fact: Regulators have recognized that the banking system is sound with strong capital levels.

Banks have significantly increased their capitalization levels and as noted, improved risk management practices in response to market demands and the post-crisis reforms. In fact, tier 1 capital ratios at the largest U.S. banks have nearly doubled since 2006.There’s no better example of the banking sector’s resilience than its performance during the COVID-19 pandemic and the strong support banks of all sizes provided the economy. Imposition of additional regulatory burdens imposed by Basel III endgame is unnecessary and potentially restrictive for banking operations and economic growth — a clear case of a solution in search of a problem.

3 Misconception: Higher capital requirements are needed for trading and underwriting activities.

Fact: Higher capital requirements on “trading” are unjustified and will harm pension funds, farmers, insurance companies, airlines and other end users seeking to hedge their risk.

The Basel III endgame will increase the capital requirements for banks’ capital markets activities by 75 percent, affecting end users throughout the economy and pushing many of those activities outside the banking system. In particular, the rewrite of the “market risk” rule will reduce hedge recognition, is duplicative of the Federal Reserve’s stress test, and will penalize end-users looking to manage their risks.

All traded products, including bonds, will have reduced liquidity as banks are required to pull back from markets. Pension funds, insurance companies, airlines, smaller banks, farmers and businesses generally will have fewer options to hedge their risks. These requirements will weaken the strength and depth of the U.S. capital markets — the best in the world — and consequently weaken the U.S. economy.

4 Misconception: The Federal Reserve knows how the proposal will impact the economy.

Fact: Although Barr asserted a minimal impact, regulators have acknowledged the need for additional data.

The regulators have clearly acknowledged the need for more data to understand how much capital the proposed rule would require covered banks to hold. Collecting and analyzing these data are essential prerequisites to properly and accurately weighing the relative costs and benefits of the rule. For example, at the Federal Reserve Board meeting where the proposal was discussed and approved, multiple staff members described the need for collecting data to support the proposal, stating at various points: “Following issuance of the proposal, staff plans to undertake a data collection. Such data collection would allow us to refine our estimates of the impact of the proposal. This information will inform finalization of the rule.”

At this time, no data collection has been initiated. It is essential that the banking agencies conduct the data collection, publicly announce results, and re-propose the proposal so the public can provide informed comment.

5 Misconception: Adoption of Basel III endgame will improve international harmonization.

Fact: Capital requirements in the U.S. are far more restrictive than the Basel standards.

Numerous policy makers who developed the international standard stated that “the focus of the exercise was not to increase capital,” and when the Basel III endgame framework was agreed internationally in 2017, then –Treasury Secretary Steven Mnuchin stated that it would “help level the playing field for U.S. firms and businesses operating internationally.”

However, the proposal released by the banking agencies in July adds layers of capital and complexity to the international standard. At nearly every point, the proposal would increase capital requirements for large U.S. banks and place them at a competitive disadvantage versus their foreign counterparts.

6 Misconception: The Basel III endgame will not affect small banks.

Fact: If adopted, the Basel III endgame will indeed have wide-ranging impacts on the economy and on smaller banks.

The U.S. banking system benefits enormously from its diversity, but no bank operates in isolation. Community bankers have extensive relationships with other banks throughout the economy. Increases in capital requirements for mortgage market participants, derivatives market-makers, custody and clearing banks, and participants in syndicated and other shared credit transactions will constrain liquidity in many areas of the financial system, and small banks will feel the effects. Their ability to hedge risks from credit exposures and interest rate shifts will become more limited. Moreover, their customers, such as farmers, will also see their hedging options constrained, and many will likely be viewed as riskier credits for the community banks that lend to them and have to pay higher financing costs as a result.

Take the case of a new $4 billion electric vehicle battery plant in De Soto, Kansas. One or more large banks will provide and arrange financing for the construction of the factory. Community banks in the region will provide home loans, credit cards, and other banking services to the 4,000 employees employed at this factory. In addition, these smaller banks will also provide credit services to the scores of small businesses that will crop up to service the new community around the factory. Yet the capital proposal would make it difficult for large banks to finance the battery project. Without large banks, the factory would not get built, local residents would be denied employment opportunities, community banks would miss growth opportunities, and the U.S. economy would be less resilient.

7 Misconception: The Basel III endgame would have prevented Silicon Valley Bank’s collapse.

Fact: No amount of capital can stop the kind of deposit outflows seen at SVB.

SVB failed because of fast growth and poor risk management, creating a liquidity problem. The Basel III endgame does not address liquidity risk; rather, it focuses on credit, operational and trading risks. No reasonable amount of capital would have prevented SVB’s failure.

Hu Benton is SVP and policy counsel for prudential regulation and asset management at ABA. Hugh Carney is SVP for prudential regulation and asset management at ABA. He previously served as a senior attorney for the Office of the Comptroller of the Currency.

ABA Viewpoint is the source for analysis, commentary and perspective from the American Bankers Association on the policy issues shaping banking today and into the future. Click here to view all posts in this series.