Basel Endgame Rules: A Change Is Coming

The Announcement and Its Sources

Last week, the vice chairman of the Federal Reserve Board, Michael S. Barr, gave prepared remarks at the Brookings Institution announcing a significant recalibration of the Fed's Basel Endgame Proposal ("BEP"), issued in July 2023, which has been subject to considerable controversy and conflict. Until recently, Fed representatives had vigorously defended the BEP as reasonable and consistent with international standards. For example, in an October 9, 2023, speech before the American Bankers Association, Vice Chair Barr gave a robust defense of the BEP as proposed and contended that the proposed rules would only increase the capital levels required to be held by banks for credit risk by up to three basis points (0.03%).[1]

Nonetheless, the BEP attracted broad criticism, most falling into the following general areas:

• Requiring significant amounts of additional capital where the historic record suggested none was needed.
• Parts of the underlying analysis were based on data derived from banks operating outside the United States.
• Provision of insufficient evidence for justifying the elimination of banks' internal models for calculating capital requirements for credit risks and for increasing capital requirements for mortgage and consumer loans.
• Failure to consider the material overlap between the Fed's annual supervisory tests and the capital requirements included in the BEP, thus resulting in duplicative charges for the same risks, particularly operational and market risks.
• A heavy reliance in the preliminary impact estimates on banking organizations' Basel III quantitative impact statements ("QIS") conducted before the introduction of the U.S. Notice of Proposed Rulemaking. (Indeed, the agencies had proposed continuing to collect data during and after the comment period rather than before.)
• A reliance on data and analysis that the agencies had not made available to the public, in violation of the Administrative Procedure Act ("APA").

An Apparent Olive Branch

In his Brookings speech, however, Vice Chair Barr struck a tone that appeared conciliatory to the Fed's critics. He described certain modifications to the BEP that he intended to recommend to the Federal Reserve Board as part of a major re-proposal, which then would receive a new round of vigorous comment and debate. That was greeted as mostly welcome news, and it certainly demonstrated that the vice chair has been listening to and considering the opposition in some detail. However, one may fairly ask what has changed to lead to this apparent course correction? After first providing an overview of the most relevant changes, we will then offer our views as to the underlying causes for this development.

The Vice Chair's Recommendations

Here are the highlights of the most significant changes:

Relief regarding mortgage and retail/card lending: There will be a softening of the required capital to be held in connection with mortgage-related assets and retail lending. Vice Chair Barr indicated that upon further study of loss data, the proposal could be trimmed back, since those levels may result in a reduction of the risk weights for mortgage and retail lending, particularly with respect to first-time homeowners and lower-income families. Barr will recommend reducing the calibration for residential real estate exposures and will recommend lowering the capital requirements for credit card exposures (i) when a borrower uses only a small portion of the committed line, and (ii) for charge cards with no pre-set credit limits.

Narrowing the scope: Banks with assets between $100 and $250 billion will no longer be subject to the BEP changes other than the requirement to recognize unrealized gains and losses of their securities in regulatory capital (an effort to solve for the "Silicon Valley Bank Problem").

Readjustment of risk weights: The vice chair indicated he would recommend that the new proposal readjust risk weights for several other levels of assets, such as low-risk corporate exposures to certain regulated entities that a bank determines to be investment grade and that are not publicly traded, such as pension funds, certain mutual funds and foreign equivalents.

Operational risk: He indicated he would recommend that the agencies would no longer adjust a firm's operational risk charge based on its operational loss history and that fee income be calculated on a net basis regarding its contribution to the operational risk capital requirement.

Internal models: He plans to recommend changes to facilitate banks' ability to use internal models for market risk. This may allow needed flexibility by, for example, allowing a card issuer to apply a lower risk weight to a portion of a portfolio supported by a partner, thus potentially freeing up assets for other purposes such a supporting a partner loss sharing program.

Overall capital reductions from original proposal: He noted that these changes would result in a significant overall trimming of capital requirements. For banks with under $100 billion in assets, capital requirements would go up about 0.5%. For banks between $100 and $250 billion, capital would go up approximately 3% to 5%; and for G-SIBs, capital levels would increase approximately 9% as opposed to the 16% originally proposed.

Industry Reaction—Did Resistance Pay?

These recommendations have received a muted welcome by the banking community, with many bankers opining they did not go far enough. (Hearing of the proposed overall capital level reduction, the chair of a U.S. G-SIB characterized it as the difference between "death and despair.") However, this is only the beginning of the process. The re-proposal has not yet been made, and as in most rulemaking, the devil will be in the details. We can expect additional areas of reassessment, debate, contention, and, perhaps, compromise.

As for what might be driving this extensive re-proposal, we are not entirely certain. Surely the basic facts have not changed from the vice chair's October 9, 2023, full-throated defense of the BEP. In searching for a reason, we note FRB Chairman Powell's July 9, 2024, congressional testimony that the BEP would be reviewed and probably revised in detail. We do not think it was an accident that his comments came four business days after the Supreme Court's watershed ruling in Loper Bright Enterprise v. Raimondo, which eliminated Chevron deference and curbs federal agencies' ability to use statutory gaps or ambiguities to justify overbroad regulation. Moreover, with the Supreme Court's renewed focus on agency compliance with the letter and spirit of the APA, and with a looming threat of APA litigation from a series of trade groups, it is possible that Chair Powell and Vice Chair Barr concluded that for the BEP, discretion may be the better part of valor. They may wish to avoid the fate of other regulators who, as the Editorial Board of The Wall Street Journal recently put it, "keep rewriting laws as they see fit [with] the result … that they keep losing in court in humiliating fashion." ("All the President's Legal Defeats," The Wall Street Journal, Sept. 12, 2024.)  

What It Could Mean Moving Forward

We believe that the impact of the re-proposal is tightly related to the quality of the record and the thoroughness of analysis that must support a major rulemaking of this kind. Take, for example, Chamber of Commerce of the United States, v. SEC, 85 F.4th 760 (5th Cir. 2024), in which the 5th Circuit struck down the SEC's stock buyback rule based on the commission's failure to conduct a proper cost benefit analysis. Similarly, in the case of the BEP, it appears that some of the data relied on by the Fed was erroneous, some was based on experiences of banks outside the U.S., some was missing altogether, and some (e.g., regarding operational risk) was not based on any data at all but on a generalized sense of "experience" that the risk was "inherent." The re-proposal will need much more to pass muster.

Loper Bright and other recent litigation involving administrative rulemaking indicates the rapidly increasing importance of high quality data and credible analyses. Deference will no longer save a sloppy cost benefit analysis or fill the gaps created by missing data analyses. In that sense, the re-proposal is quite healthy because it will require the Fed and its staff economists to undertake robust cost benefit analyses, QIS, and other data assessments to which the industry can react. And it will provide an opportunity to engage with industry stakeholders in better understanding the downstream impacts of these changes. One can safely assume that there will be no shortage of comments and data analysis offered to the Fed in connection with the re-proposal. This new seriousness about the quality of an administrative record is a good thing and encourages a sharper focus on the details of what the APA requires.

There is a major body of work ahead of the Fed, and we have only the broadest kind of directional indications from Vice Chair Barr. Much more is in the pipeline. Nonetheless, the BEP will be a critical chapter in the evolution of not only the safety and soundness of U.S. banks, but of the ability of banks to lend and to support American businesses and consumers through good times and bad. Once the details are on the table, we will report back on exactly how much of a change is going to come.