The banking sector is on the brink of a significant change as regulators prepare to unveil a new proposal: the “Basel III endgame.” Designed to fortify the financial stability of large banks, this initiative is set to introduce more stringent bank capital requirements. While the full details are yet to be revealed, the impact of these rules is expected to be far-reaching.
Who does it affect?
In the US, the Basel III endgame is tailored for banks with assets totalling US$100 billion (£82 billion) or more. For these financial giants, the endgame could usher in an overhaul of their capital management strategies, leading to downstream effects on lending and trading activities. Naturally, this has sparked a debate in the banking industry.
In the UK, the Prudential Regulation Authority (PRA) recently announced a six-month extension for the implementation of the final phase of Basel III reforms. This decision pushes the implementation date to 1 July 2025.
In light of this extension, the PRA aims to condense the transition period for the final Basel 3.1 policies, to achieve full implementation by 1 January 2030, aligning with the framework outlined in its November 2022 consultation paper CP 16/22.
To address industry concerns related to credit risk and output floor proposals detailed in CP 16/22, the PRA will release its ‘near-final’ Basel 3.1 framework in two phases.
In Q4 2023, near-final policies on market risk, credit valuation adjustment risk, counterparty credit risk, and operational risk will be unveiled.
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Subsequently, in Q2 2024, the remaining components of the CP16/22 proposals, encompassing ‘near-final’ plans for credit risk, the output floor, and reporting and disclosure requirements, will be published.
The Basel III framework
The “Basel III” framework was originally conceived after the global financial crisis of 2007-2009. It was developed by the Basel Committee on Banking Supervision, a body assembled by the Bank for International Settlements (BIS) in Basel, Switzerland. The primary goal of Basel III is to establish uniform minimum capital standards that can help banks withstand the losses incurred during turbulent economic times.
What’s the Endgame?
The “endgame” represents the final phase of Basel III, which was agreed upon in 2017. This proposal is all about refining how banks calculate their capital requirements based on the risks associated with their activities. Some of the key components are:
Credit Risk: One major change is the expected discontinuation of banks’ ability to use their internal risk models to determine capital needs for lending activities, such as mortgages and corporate loans. Regulators argue that these internal models can sometimes underestimate risk, as banks aim to keep their capital costs low. Instead, uniform modelling standards may be imposed across large banks.
Market and Trading Risks: The proposal is also anticipated to introduce fresh requirements for assessing market risks and potential trading losses. Regulators have noted that the current methods often underestimate these risks. While banks may still use their internal models, particularly for complex risks, they will be required to model trading risks at the level of individual trading desks.
Operational Risk: Operational risk, which encompasses potential losses from unexpected sources like internal policy failures, management errors, litigation costs, or external events, is another key area. Regulators are seeking to replace existing internal models with standardised approaches that consider a bank’s various activities and past operational losses when determining capital levels.
Concerns and debates
Banks are raising concerns that this approach may significantly increase costs for institutions relying heavily on non-interest fee income, such as credit card and investment banking fees. Some banks worry that these changes could lead to disproportionately higher capital requirements unless capped. They argue that additional capital is unnecessary and could adversely affect the economy.
While the banking sector has hoped for regulatory relief in other areas, regulators are determined to prioritise financial resilience. They point to the recent failures of three banks earlier this year as evidence of the need for vigilance.
The Basel III endgame signifies a significant transformation in banking regulation. While the rules have been years in the making, the ongoing debate revolves around whether these changes are justified, with banks emphasising their well-capitalised positions and regulators emphasising the importance of safeguarding financial stability. The specifics of the Basel III endgame are yet to be unveiled, but its potential impact is already generating substantial interest and discussion within the financial industry.