Michael S Barr: The next steps on capital
Speech by Mr Michael S Barr, Vice Chair for Supervision of the Board of Governors of
the Federal Reserve System, at the Brookings Institution, Washington DC, 10
September 2024.
* * *
1
Thank you for inviting me to speak today. Since I joined the Federal Reserve Board as
Vice Chair for Supervision, I have spoken many times about the importance of bank
2
capital to the safety and soundness of banks and the stability of the financial system. It
is critical that banks have the capacity to continue lending to households and
businesses through times of stress. Bank capital is a key component of this resilience.
And bank capital rules help to ensure that banks are holding capital commensurate with
the risks of their activities and the risks that they pose to the U.S. financial system. But
capital has costs too. As compared to debt, capital is a more expensive source of
3
funding to the bank. Thus, higher capital requirements can raise the cost of funding to
a bank, and the bank can pass higher costs on to households, businesses, and clients
engaged in a range of financial activities. These activities are critical to a
wellfunctioning economy that works for everyone. That's why it is important to get the
balance between resiliency and efficiency right.
Today, I'll return to these themes in the context of two rules of great public interest: The
Basel III endgame proposal and the proposal to adjust the capital surcharge for global
systemically important banks (G-SIB).4
The path forward
A little over a year ago, the Board sought comment on those two proposed rules, which
would modify risk-based capital requirements for large banks. We received a great
number of comments on the provisions in the proposal, as well as on the justifications
and analysis that underlie those provisions.
Since that time, we have been hard at work analyzing the comments and the data we
collected to evaluate the combined impact of these proposals. We have spoken with a
wide range of stakeholders, including banks, academics, public interest groups,
consumers, businesses, other regulators, Congress, and others. As you would expect
in a project as technical and consequential as this one, I have had many productive
meetings with Board colleagues and our fellow federal bank regulatory agencies, the
Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the
Currency (OCC).
This process has led us to conclude that broad and material changes to the proposals
are warranted. As I said, there are benefits and costs to increasing capital
requirements. The changes we intend to make will bring these two important objectives
into better balance, in light of the feedback we have received. The changes to the
endgame proposal have been a joint effort with my counterparts at the FDIC and the
OCC.
I intend to recommend that the Board re-propose the Basel endgame and G-SIB
surcharge rules. This will provide the public the opportunity to fully review a number of
key broad and material changes to the original proposals and provide comment. We will
accept public comments on any aspect of the Basel endgame and G-SIB surcharge
proposals.
The changes in the endgame re-proposal will cover all major areas of the rule: credit
risk; operational risk; and market risk. Banks with assets between $100 and $250 billion
would no longer be subject to the endgame changes, other than the requirement to
5
recognize unrealized gains and losses of their securities in regulatory capital. These
changes reflect the feedback we have received from the public, improve the tiering of
the proposal, and better reflect risks. I will also recommend changes to the G-SIB
surcharge proposal to better align the capital surcharge for a G-SIB with its systemic
risk profile.
Taken together, the re-proposals would increase aggregate common equity tier 1
capital requirements for the G-SIBs, which are the largest and most complex banks, by
9 percent. For other large banks that are not G-SIBs, the impact from the re-proposal
would mainly result from the inclusion of unrealized gain and losses on their securities
in regulatory capital, estimated to be equivalent to a 3 to 4 percent increase in capital
requirements over the long run. The remainder of the re-proposal would increase
capital requirements for non-GSIB firms still subject to the rule by 0.5 percent.
While these proposed changes affect some of the most important aspects of the
proposals, the agencies have not made final decisions on any aspect of the
reproposals, including those that are not explicitly addressed in the re-proposal. The
public should not view any omission of a potential change in these re-proposals as an
indication that the agencies will finalize a provision as proposed. We continue to
consider comments already received on the 2023 proposal, and we will consider those
comments together with any comments submitted on the re-proposals as part of any
final rulemakings. This is an interim step. Let me reiterate that we are open to
comments on any aspect of the proposals. Now, I will turn to the changes.
Credit risk
I will begin with an overview of the changes I will recommend to the capital
requirements for credit risk, which protect against the risk that a bank's loans will not be
fully repaid. These changes include reducing the risk-weights for residential real estate
and retail exposures, extending the scope of the reduced risk weight for certain low-risk
corporate debt, and eliminating the minimum haircut for securities financing
transactions.
First, I intend to recommend that the Board lower the proposed risk-weighting for loans
secured by residential real estate and loans to retail customers. The original proposal
introduced more risk-sensitive approaches for residential real estate and retail
exposures, but calibrated them to be higher than the Basel standard to promote
domestic competitive equity. The agencies received significant comments on the
proposed calibrations. Some commenters argued that the elevated risk weights would
overstate the risk for these loans given their loss history. Others argued that the risk
weighting would affect home affordability and homeownership opportunities, particularly
for first-time homebuyers, minority communities, and low- and moderate-income
borrowers, and could reduce the availability and affordability of retail credit.
I will recommend that we reduce the calibration for residential real estate exposures so
that it is in line with the calibration developed in the Basel process. With this change,
allin capital requirements, including for operational and credit risk, will be lower on
average than they are currently for mortgages up to 90 percent loan-to-value ratio, and
about the same as they are now for mortgages up to 100 percent loan-to-value. With
respect to loans to retail customers, I intend to recommend that we adopt the Basel
standard, with two exceptions - first, we would lower the capital requirements for credit
card exposures where the borrower uses only a small portion of the commitment line,
and second, we would lower the capital requirement for charge cards with no pre-set
credit limits.
The second proposed change related to credit risk would extend the reduced risk
weight for low-risk corporate exposures to certain regulated entities that a bank judges
to be investment grade and that are not publicly traded. The original proposal provided
this preferential treatment only to investment-grade corporates that were publicly traded
because the financial disclosure requirements for these entities facilitate market
participants' assessments of their financial condition, which in turn provide additional
information for banking organizations to use when assessing these entities' credit risk.
There were many comments that the preferential treatment should be extended further,
including to regulated entities that are also subject to substantial regulatory discipline
and substantial transparency requirements. Consistent with our objective of increasing
risk sensitivity in capital requirements, I plan to recommend to the Board that we extend
the reduced corporate risk weight to regulated entities - including regulated financial
institutions that are not banks, such as pension funds, certain mutual funds, and foreign
equivalents - that are investment-grade but not publicly traded.
Third, I intend to recommend that the Board not adopt the capital treatment associated
with minimum haircut floors for securities financing transactions. The proposal included
heightened capital requirements for repo-style transactions and eligible margin loans
that did not meet minimum margin requirements. While consistent with the Basel
standard, several other major jurisdictions have not adopted this approach. Not
adopting the minimum haircut floors will allow time to seek greater international
consensus on this important topic before deciding on whether and how to implement
such an approach in the United States.
Equity Exposures
Let me speak to the treatment of tax credit equity financing exposures. I plan to
recommend that we significantly lower the risk weight for tax credit equity funding
structures, given the lower inherent risk in these structures compared to many other
equity investments. The revised lower risk weight for these exposures of 100 percent
would reflect this lower risk and be consistent with the approach we take for other tax
credit investments, such as the low-income housing tax credits.
Operational risk
Next, let me speak about three changes I intend to recommend for the proposed capital
treatment of operational risk, which is the risk of losses from inadequate or failed
processes, such as from fraud or cyberattacks. First, I plan to recommend that we no
longer adjust a firm's operational risk charge based on its operational loss history. This
change will reduce fluctuations in a bank's operational risk capital requirements over
time.
Second, I plan to recommend to the Board that we calculate fee income on a net basis
in calculating its contribution to the operational risk capital requirement. The original
proposal would have measured the contribution of fee-based activities based on gross
revenues, instead of net income, which is revenues minus expenses. Moving to net
income for fee-based activities-specifically, by netting noninterest income and expenses
(except for operational losses)-would produce more consistency in how operational risk
is measured across bank activities, as interest and trading income and expenses are
already measured on a net basis under the proposal. This change would also produce
more consistent operational risk capital requirements across banks because the
approach is less sensitive to the differences in accounting practices across banks.
Third, I plan to recommend to the Board that we reduce operational risk capital
requirements for investment management activities to reflect the smaller historical
operational losses for these activities relative to income. The agencies received
comments suggesting that some fee-based business lines have incurred meaningfully
lower operational losses than other business lines. We have found evidence that
investment management has historically experienced noticeably low operational losses
relative to income produced.
Market risk and derivatives
Now, I'll speak to the capital treatment for a bank's trading activities and its derivatives
activities. The endgame proposal included a number of important improvements relative
to the current market risk capital framework, including to incorporate lessons learned
from the 2007-09 financial crisis that have not been sufficiently addressed in the current
framework. It would permit firms to use internal models to capture the complex
dynamics of most market risks but would put certain constraints on banks' models and
provide fallbacks in areas where modeling practices are not adequate.
We received numerous comments on ways to improve this part of the proposal. I plan
to recommend that we make changes to facilitate banks' ability to use internal models
for market risk. For example, the re-proposal will introduce a multiyear implementation
period for the profit and loss attribution tests that are used to confirm that models are
working as intended. This extended transition period would allow banks to gain
experience with the tests and provide time to improve their systems and processes and
address any potential gaps in data and model performance. In addition, the re-proposal
would contain a few additional adjustments to improve incentives for a firm to model its
exposures.
Moreover, we will clarify that uniform mortgage-backed securities positions would be
treated as having a single obligor, regardless of whether they were issued by Freddie
Mac or Fannie Mae. This change will enable firms to recognize hedging across these
securities.
With respect to derivatives activities, I plan to recommend that the Board adjust the
capital treatment for client-cleared derivatives activities by reducing the capital required
for the client-facing leg of a client-cleared derivative. This change would better reflect
the risks of these transactions, which are highly collateralized and subject to netting and
daily margin requirements. This also would avoid disincentives to client clearing, which
I'll return to later.
Tiering
Let me turn to tiering. The largest, most complex firms should be subject to the most
stringent requirements, in light of the costs that their potential failure would impose on
the broader financial system and thus on businesses and households. Under the
reproposal, G-SIBs and other internationally active banks would be subject to the most
stringent set of requirements, including the new credit risk and operational risk
requirements, and the revised frameworks for market risk and CVA frameworks.
Capital requirements for large banks that are not G-SIBs can be simpler while still
supporting resilience. I am recommending a number of changes to better reflect this
principle. For firms with assets between $250 and $700 billion that are not G-SIBs or
internationally active, the re-proposal would apply the new credit risk and operational
risk requirements; however, it would apply the frameworks for market risk and CVA
frameworks only to firms that engage in significant trading activity. Further, the
reproposal would revert to the simpler definition of capital - the numerator in the capital
ratio - for these firms that is currently in place, with the exception of applying the
requirement to reflect unrealized losses and gains on certain securities and other
aspects of accumulated other comprehensive income (AOCI). The re-proposal would
maintain this element to better reflect interest rate risk in capital, a problem that played
a major role in last March's bank failures.
For large banks with assets between $100 and $250 billion, the re-proposal would not
apply the credit risk and operational risk frameworks of the expanded risk-based
approach to these banking organizations, maintaining a simpler capital framework for
these less complex firms. For these firms, the re-proposal would also revert to the
simpler definition of capital for these firms that is currently in place, with the exception of
applying the requirement to reflect unrealized losses and gains on certain securities and
other aspects of AOCI.
G-SIB surcharge proposal
As I noted, last July, we sought comment on proposed revisions to the G-SIB
surcharge, to better reflect the systemic risk of each G-SIB. In particular, the proposal
would make adjustments to limit "window dressing" by requiring banks to report
indicators as average values instead of on a point-in-time basis. It would also reduce
"cliff effects" by calculating a G-SIB's capital surcharge in 0.1 percent increments
instead of 0.5 percent increments. And the proposal would adjust how we measure
some systemic indicators to better align them with risk.6
The goal of the 2023 proposal was to improve the risk sensitivity of the G-SIB
surcharge. Commenters provided helpful feedback regarding the proposal's potential
impact on certain types of activities, such as client clearing of derivatives. We are still
considering these comments, but let me speak to areas where I will recommend making
changes to the original proposal.
First, I'll speak to the treatment of cleared derivatives. The proposal would have
increased the extent to which client-cleared derivatives contribute to a bank's G-SIB
surcharge, to promote consistency of the measure. However, commenters argued that
the measure might result in higher costs and more volatility for derivative end users and
might reduce incentives to provide clients' access to central clearing. While it is
important for our capital rules to be risk-sensitive, it is also important that we consider
the impact of our rules in the broader market context. Central clearing of derivatives is a
critical tool that can help improve transparency and reduce systemic risk. To avoid
disincentives for client clearing, I intend to recommend to the Board that we not adopt
the proposed changes to capital requirements associated with client clearing.
Second, let me speak to changes in the surcharge proposal that I will recommend to
keep the measures we use up-to-date. The U.S. G-SIB surcharge was set nearly nine
years ago, and the growth in the economy since 2015 has meant that G-SIBs'
measures of systemic risk have increased, even for firms whose share of domestic or
global economic activity has not increased. The Board noted the potential for this effect
in the original 2015 G-SIB rule. While it did not provide a mechanism to automatically
adjust for economic growth at that time, the Board stated that it would periodically
reevaluate the framework.
As part of the G-SIB re-proposal, I intend to recommend that we improve the calculation
of the capital surcharges for G-SIBs by reflecting changes in the global banking system
since the Board adopted the G-SIB surcharge in 2015. In addition, for the future, I
intend to recommend that we account for effects from inflation and economic growth in
the measurement of a G-SIB's systemic risk profile. As a result, a G-SIB's surcharge
would not change based simply on growth in the economy.7
Conclusion
The journey to improve capital requirements since the Global Financial Crisis has been
a long one, and Basel III endgame is an important element of this effort. These
reproposals bring us closer to completing the task.
The broad and material changes to both proposals that I've outlined today would better
balance the benefits and costs of capital in light of comments received, and result in a
capital framework that appropriately reflects the risks of bank activities and is tiered to
the banking sector. They also bring the proposals broadly in line with what other major
jurisdictions are doing. And what does this all mean? A safer and fairer banking system.
My goal, throughout my nearly 30 years in this field, has always been to help ensure
that the banking system can support households and businesses of all types, during
good times and bad.
In addition to the re-proposals outlined today, we are looking carefully at how our stress
test complements the risk-based capital rules to help ensure our overall framework
supports a resilient and effective banking sector. We are attentive to the interactions
across all components of our capital framework as well as the combined burden and
benefits, and we take these issues seriously. In all of our work, we will continue to seek
an approach that helps to ensure financial system resiliency and supports the flow of
credit to households and businesses. It is most imperative that we get this right.
Thank you.
1
The views I express here are my own, and not necessarily those of my colleagues on
the Board of Governors of the Federal Reserve System or the Federal Open Market
Committee.
2
See Michael S. Barr, "Why Bank Capital Matters" (speech at the American Enterprise
Institute, Washington, DC, December 1, 2022), and Michael S. Barr, "Holistic Capital
Review (PDF)" (speech at the Bipartisan Policy Center, Washington, DC, July 10, 2023).
3
Under standard corporate finance theory, a firm should be indifferent between debt
and equity, but in practice, as compared to debt, equity is a more expensive source of
funding to a bank given the structure of our laws and markets, the presence of deposit
insurance and other government support, and other factors. See, e.g., Franco
Modigliani and Merton H. Miller, "The Cost of Capital, Corporation Finance and the
Theory of Investment," The American Economic Review 48 (June 1958): 261-297, and
Ron J. Feldman, Gary H. Stern, and Paul A. Volcker, Too Big to Fail: The Hazards of
Bank Bailouts (Washington: Brookings Institution Press, 2009).
4
The G-SIB surcharge is an additional layer of capital just for the G-SIBs, and it is
measured on several factors of each G-SIB, specific to their individual risks.
5
To the extent that such a firm has large trading operations, it would also be subject to
the revised market risk framework.
6
With regard to the adjustments to address window dressing and cliff effects, these will
have a one-time impact on banks that carefully manage their operations to lower
surcharge buckets, but should improve the efficiency and risk-sensitivity of the measure
over time.
7
The re-proposal would update the method 2 coefficients to reflect changes from 2015
until the present using a methodology that is consistent with the Board's original
calibration in 2015. Specifically, the supplemental proposal would update the method 2
coefficients for each of the systemic indicators for the size, interconnectedness,
complexity, and cross-jurisdictional activity categories from 2015 until the present using
the most recent available two-year average of aggregate global indicator amounts and
the corresponding three-year average of euro/U.S. dollar exchange rates. Going
forward, it would also include a mechanism to annually adjust the method 2 coefficients
for each of the systemic indicators for the size, interconnectedness, complexity, and
cross-jurisdictional activity categories based on U.S. inflation and real economic growth.
This mechanism would use a three-year moving average of annual nominal U.S. gross
domestic product (GDP) growth to adjust these coefficients on an annual basis.