Following turmoil in the U.S. banking industry in March 2023 after several banks failed, U.S. regulators have put forth regulatory proposals to increase the strength and resilience of the U.S. banking system. The proposals, known as the Basel III endgame proposal and the global systemically important bank (GSIB) surcharge proposal, modify capital requirements for large banks and detail how U.S. regulators (the Federal Reserve, Office of the Comptroller and Currency, and the Federal Deposit Insurance Corp. [FDIC]) plan to implement the capital standards that the Basel Committee On Banking Supervision finalized in 2017 and 2019. Other regulatory proposals pertaining to liquidity and interest rate risk management may follow.

The proposals would likely result in more stringent capital requirements for many U.S. banks. To do so, regulators aim to standardize aspects of the capital framework, reduce the ability of banks to rely on internal models, and make any bank with more than $100 billion in assets subject to most of the same requirements applicable to the GSIBs.

We don't expect any downgrades due to the proposals because, given the length of time of transition to the new rules, we believe all banks subject to the proposals will be able to meet their more stringent capital requirements. In terms of upgrades, the most likely path for any positive rating actions due to the regulation, if they were to occur, would be on an idiosyncratic basis and could stem from a specific bank needing to build and hold a significant amount of additional capital due to the regulation.

Comments, which were originally due by Nov. 30, 2023, have been extended to Jan. 16, 2024. Once the proposal is finalized, transitioning to the new framework will begin July, 1 2025, with full compliance by July 1, 2028.

Below, S&P Global Ratings addresses some of the key tenets of the proposal, as well as implications for the banking industry and ratings.

Frequently Asked Questions

Which banks are in the scope of the proposal?

The proposal generally applies to banks that have greater than $100 billion in assets, also known as category I-IV banks under the tailoring rules (see chart 1). In addition, the market risk component of the proposal would apply to some banks that have less than $100 billion in assets but undertake significant trading activity (average aggregate trading assets and trading liabilities of greater or equal to $5 billion or representing greater or equal to 10% of total assets, or is required by its regulator to calculate market risk).

Chart 1

How may the proposal, if enacted, affect ratings?

We believe regulators having a more stringent view of bank capital requirements, potentially increasing capital requirements and more broadly applying the tightest capital standards to all banks with at least $100 billion in assets, is an incremental positive for creditors. As such, this would be a step--perhaps alongside potential moves to tighten requirements pertaining to liquidity, interest rate risk, and resolution--that could represent an important change in the regulation and supervision applied to all large banks.

We don't expect any downgrades because we believe all banks subject to the proposals will adhere to more stringent capital requirements via capital build--if needed--and balance sheet optimization. Whether the proposals will result in higher ratings is uncertain. As it pertains to the Basel III endgame, the most likely path for any positive rating actions would be from a specific bank needing to build and hold a significant amount of additional capital due to the regulation.

S&P Global Ratings' primary measure of assessing a bank's capital strength is our risk-adjusted capital (RAC) ratio. It's a proprietary measure of capital derived by taking a bank's shareholder equity, plus its allowable hybrid securities, less some adjustments, and dividing this amount by our derivation of its risk-weighted assets. These risk weights are standardized by asset class and determined by our view of a country's economic risk (the riskier our view of a jurisdiction, the higher the risk weights). Holding higher capital in the numerator of our ratio (total adjusted capital) could raise a bank's RAC ratio, possibly leading to a more favorable assessment of its capital and a higher rating. (See appendix table 4 for banks' RAC ratio as of June 30, 2023, and appendix table 5 for RAC thresholds that may garner a higher capital assessment score under our criteria.)

Chart 2

At a high level, what are the main changes of the Basel endgame proposal compared with existing bank capital rules?

The proposal aims to implement the final components of the Basel III agreement and apply a broader set of capital requirements to more large banks, generally those with $100 billion or more in assets. Therefore, it would generally align the risk-based capital requirements for Category III and IV capital banks with those of Category I and II banks, providing a single approach for all large banks. (Although the GSIB surcharge--applied to Category I banks only--would still make their capital requirements more stringent than for Category II-IV banks).

The proposal changes the methods a bank would use to calculate its RWAs for credit, market, and operational risk, for the most part removing the ability to use internal models (see appendix for more detail of the proposed changes for the different capital risk categories).

All banks in scope would need to calculate RWA under both a standardized approach as well as a new expanded risk-based approach (ERBA). The ERBA would replace the current advanced approach, which currently only applies to Category I and II banks. Under the proposal, all banks--Categories I-IV--would be bound by the higher of the RWAs calculated under either the standardized or ERBA approach (see chart 3).

In contrast to the current advanced approach, the proposal would reduce the ability of banks to use internal models to calculate RWA. Banks would still be able to use some internal models to calculate market RWA, but those models would be subject to enhanced requirements for approval and performance, and a new "output floor." The proposal would eliminate the use of internal models for calculating credit and operational RWA.

The expanded risk-based approach aspires to be more risk-sensitive than the current standardized approach by incorporating more credit-risk drivers (for example, borrower and loan characteristics) and explicitly differentiating between more types of risk (for example, operational risk). In this manner, the expanded risk-based approach would aim to better account for key risks faced by large banks and would likely become the binding constraint due to its inclusion of an operational risk component.

Chart 3

There will also be a transition to the implementation of the ERBA risk weights. It will not be fully implemented until July 2028, with only 80% of risk weights derived under the ERBA in effect by July 2026.

Table 1

Are there other changes in the proposal that apply only to Category III-IV banks?

Yes. A substantial proposed change would eliminate the ability of Category III and IV banks to opt out of recognizing most elements of additional other comprehensive income (AOCI) and related deferred tax assets and liabilities in regulatory capital. AOCI includes unrealized gains and losses from available-for-sale (AFS) securities. (Category I and II banks are already disallowed from this opt out.)

Given today's high interest rates, many banks have sizeable unrealized losses in their AFS securities portfolios. Notably, some of these banks would have significantly lower capital ratios if AOCI were included in their capital ratios today (see appendix for our estimate of the impact).

By the time the final phase-in of the proposal would be reached (2028), we believe all category III-IV banks would be able to reach their required minimum levels inclusive of AOCI with a management buffer of 100 basis points (bps). To do so, some banks would likely need to retain a higher amount of earnings in the coming years than they historically have and perhaps also make some changes on their balance sheets to reduce RWA. In addition, we expect unrealized losses on AFS securities to fall materially by 2028 as those securities move toward maturity. A decline in market interest rates, should that occur, would also accelerate the drop in unrealized losses on AFS securities.

Category IV banks would also need to meet the 3% supplementary leverage ratio (SLR) requirement that Category I-III banks already face. The proposals would also make some changes to how the denominator of the SLR is calculated. The Category I banks would continue to face an enhanced SLR (eSLR) requirement of 5%. The SLR and eSLR are non-risk-based capital metrics that consider off-balance-sheet exposures. We believe complying with this aspect of the proposal will be less onerous for most banks as their balance sheets have been declining given the outflow in deposits over the course of last year.

The proposal also calls for expanding the application of the countercyclical capital buffer (CCyB) to Category IV banks. The CCyB is a tool regulators can use to increase capital requirements in anticipation of periods they view as having elevated risk of above-normal losses. In the U.S., regulators have not yet used this tool.

Are there any changes besides the AOCI opt-out being proposed to the calculation of the numerator of banks' regulatory capital ratios?

Category III-IV banks would need to replicate the deductions Category I-II banks already make to common equity Tier 1 (CET1) capital for mortgage servicing assets (MSAs), temporary differences of deferred tax assets (DTAs), and significant investment in unconsolidated financial institutions, when those items exceed certain thresholds. Specifically, under the proposal, category III and IV banks would need to deduct from their adjusted CET1, MSAs, DTAs, and investment in the capital of unconsolidated financial institutions that exceed 10% of CET1 on an individual basis and 15% of CET1 in aggregate. Currently, Category III-IV banks only must make deductions of those items on an individual basis that exceed 25% of CET1 (with no aggregate thresholds).

Are there any floors to the calculation of capital ratios?

Yes. If the RWAs under the expanded risk-based approach were less than the output floor, the output floor would have to be used as the RWA amount to determine the expanded risk-based approach capital ratios. Specifically, the calculation of the ERBA would be subject to an output floor of 72.5% of an alternate calculation of RWA that includes the market risk-weighted assets calculated under the standardized ratio minus any amount of the banking organization's adjusted allowance for credit losses that is not included in Tier 2 capital and any amount of allocated transfer risk reserves (a reserve set up for currency risk of a bank's foreign exposures).

The floor is put in place to enhance the consistency of capital requirements and ensure models for market risk do not result in in significant reductions in capital requirements. That said, because the standardized approach does not include any calculation of RWAs for operational risk or CVA, we think it is unlikely that the output floor would have an impact on RWA calculations for most banks, particularly when the transition to ERBA is complete (see table 1).

What are the capital consequences according to regulators?

In aggregate, regulators estimate that the proposal would increase holding companies' total RWA by 20% relative to the current binding measure of RWA, thereby increasing the binding CET1 capital requirement by an estimated 16%. However, the impact varies meaningfully depending on each bank's activities and risk profile.

Regulators estimated the proposal in aggregate would increase RWAs by roughly 25% for Category I-II holding companies and 10% for Category III-IV holding companies. The impact appears greatest for GSIBs that rely more heavily on trading revenue. Regulators stated that required capital levels for trading activities could double for some banks depending on their individual business activities and use of internal models.

Positively, many banks already hold capital levels well above their regulatory minimum, and as such, we believe the transition to the new required capital levels, if enacted, should be manageable.

Many banks have put forth their own estimates of the impact to RWA and capital requirements if the proposal were to be finalized as written and before any mitigating factors can be taken. For example, JPMorgan Chase & Co. estimates that the proposal would increase its RWA by 30% and its capital requirements by 25%. But a lot of the regional banks without trading operations point to a more modest increase in RWAs. For example, PNC Financial has stated that the Basel endgame proposal would increase its RWA by 3%-4%.

Table 2

How might the proposal, if enacted, affect bank strategies and the markets?

Given that some banks would need to hold higher levels of capital, their profitability, as measured by return on equity, may be pressured to varying degrees. Furthermore, the potential need to build capital could also significantly limit their ability to return capital to shareholders through share repurchases.

As a result, we expect banks to "optimize" their balance sheets to reduce or limit the growth of RWAs--for instance, by increasing the use of moving assets off balance sheet via securitizations, loan sales, and credit risk transfer strategies. Banks could also exit businesses or strategies that have higher capital requirements and thereby generate lower risk-weighted returns, particularly those businesses that are not customer centric. Banks may also opt to hold less trading inventory than currently due to the higher capital charges for their markets-based businesses, which could in turn further dilute their ability to provide liquidity in the capital markets, and potentially promote greater prominence for nonbank players.

Banks may also look to effectively pass on a portion of the cost of higher capital requirements to their customers by raising prices on some products and expand businesses that have more favorable capital treatments under the proposal. That could include focusing more on higher credit quality customers, who garner a lower risk-weight charge under the ERBA, at the expense of less creditworthy borrowers. As a result, the proposal could further push riskier loans out of the banking system.

Banks may also reduce lines of credit for credit card usage given the proposal's introduction of a 10% credit conversion factor for unconditionally cancellable commitments under the ERBA. (In other words, unused credit card lines, which can be very significant for some banks, would receive a 10% risk weight.) Banks may also look to compete for and target credit card customers who tend to be high transactors and thereby generate significant fee income, as opposed to "revolvers"--i.e., customers that leave significant debt outstanding and thereby generate more interest income but with higher RWAs.

Banks may also be driven to further evaluate the value proposition of some of their fee-based businesses--a key strategy initiative over the years as a way to diversify from spread income. Under the proposal, fee-based revenue could result in a charge to risk weights within operational risk, and banks would therefore need to consider the regulatory capital implications in regards to new business initiatives.

The measures could prompt further mergers and acquisitions. In particular, regional banks at the lower end of the $100 billion threshold of the regulation may attempt to grow in size via acquisition so as to help support the cost of new regulation. Conversely, banks that are below $100 billion in size may be wary of rapid growth or an acquisition that could push them above this threshold.

What are the changes being proposed for the GSIB surcharge?

A bank identified as a GSIB under a regulatory methodology is required to calculate a "GSIB surcharge." That GSIB surcharge, calculated under what is known as method 2, is one component of the capital requirements applied to GSIBs. It is based on the measurement of systemic risk indicators at year-end.

Rather than measuring those indicators simply on a single date, regulators have proposed to use average daily or monthly balances for the year to calculate method 2 of the GSIB surcharge so as to eliminate period-end gaming of bank balance sheets.

Regulators also proposed that GSIB surcharges have smaller bands of 10 to 20 bps, rather than the current 50 bps band, so as to eliminate a cliff effect. The proposal also would revise aspects of the calculation of systemic indicators. Regulators estimate that these changes for the GSIB buffer would have resulted in a $13 billion increase in required risk-based capital as of year-end 2022.

What are some of the major differences of the U.S. proposal versus implementation of the Basel Committee framework in other jurisdictions?

Some of the key differences are as follows:

• The capital floor (the amount by which ERBA could be lower than standardized risk weights) starts at 50% and moves to 72.5% over five years in most jurisdictions, and in the EU there is an even longer runway for the calculation of the standardized risk weights for certain holdings; in the U.S., the proposal does not permit banks the same gradual runway and starts instead at 72.5%.
• The U.S. is the only jurisdiction in which banks are bound by the lower of the two capital ratios--standardized versus ERBA. That said, the U.S. calculation of standardized seems to be more lenient as it excludes operational risk and CVA, and thus it is unlikely to be the binding constraint once the transition to the ERBA is complete.
• Risk weights for some aspects of residential real estate and retail exposure are higher in the U.S.
• The internal loss multiplier (ILM; a multiplier to take into account a bank's average historical losses [that is used as input to calculate operational risk, see appendix]) is floored at 1 in the U.S. (it could be higher than 1 but not lower). In some jurisdictions, such as the EU and U.K., regulators have opted to set it at 1, in application of a national discretion of the Basel rules.

What are some issues banks and other market participants are raising in regards to the proposal?

Many banks are arguing that the proposal will increase pricing and reduce the availability of credit for customers, and reduce market-making capabilities, thus reducing liquidity within the U.S. capital markets.

In addition, before the proposal, banks were already pointing to calibration issues of the GSIB surcharge. For instance, certain banks argued that economic growth alone causes inflation in the calculation. Since the surcharge is multiplied by RWA to set capital requirements, the increase in RWA due to the proposal further contributes an additional need for capital.

In addition, banks believe there is double counting involved when incorporating the Fed's annual stress test to derive minimum capital levels. The annual stress test already incorporates an operational risk charge to derive the stress capital buffer (SCB; the difference between a bank's starting risk-weighted capital ratio and its minimum capital ratio during the nine quarters of the Fed's annual stress test that is part of their minimum capital required capital ratios). Banks argue that the operational risk charge within ERBA would be a form of double counting.

Some have also questioned the need to have a separate operational risk charge because credit risk and market risk events typically do not happen at the same time as an operational risk event, and so capital put aside for the former could be used for the latter.

What is the likelihood of changes being made to the proposal?

It's difficult to say. Regulators extended the comment period, and many banks have been outspoken in their criticism of it. In addition, there was dissension within the boards of the Fed and the FDIC when the proposal was put forth. Two board members at each the Fed and FDIC voted against the proposal, which could also point to some internal pressure to make alterations.

How will this proposal affect the Fed's annual stress test?

A bank's minimum capital requirement is derived by how it performs on the annual stress test. One component of a bank's minimum required capital ratio is its SCB, which is floored at 2.5% but could be higher depending how a bank fares on the stress test. The proposal calls for considering the ERBA capital ratio along with its standardized capital ratio, and using the lower of the two as the starting point of a bank's capital ratio for stress testing. Currently banks only use the standardized capital ratio as the starting point of the stress test.

All else equal, a bank's SCB, once the Basel endgame is in effect, may be lower if its RWAs have risen. That's because the way SCB is calculated (stress test losses as a percentage of RWA) would decline due to the effect of a larger denominator. This should in turn lower banks' minimum required capital ratios (for those with SCBs greater than 2.5%), partially mitigating the negative impact of RWA inflation due to the Basel III proposal.

Related Research

• U.S. Bank Outlook 2024: Facing A Slower Economy, Tighter Regulation, And A Potential Drop In Rates, Jan. 11, 2024
• EU Banking Package: Inconsistencies Temper Framework Improvements, Jan. 9, 2024
• U.S. Regulatory Proposals For Large Bank Resolutions Could Result In Higher Ratings On Bank Subsidiaries, Oct. 10, 2023

Appendix

Detailed proposed changes to bank risk weights

Proposed changes to credit risk weights.  Banks currently calculate the capital charges for credit risk by assigning set risk weights for each asset class they own. Banks currently subject to the advanced approaches (Category I-II banks) can use their internal models to calculate risk weights. If a bank were to underwrite conservatively, its advanced approaches capital charges for credit risk will likely be lower than under the standardized approaches.

The Basel endgame proposal eliminates the use of internal models (advanced approaches) to determine capital charges for credit risk. Instead, banks would continue to use the current standardized approach (with some changes for market risk) and would also need to calculate credit risk capital requirements using the ERBA.

Some key aspects of ERBA credit risk weights include:

• Credit cards and home equity lines of credit would have a 10% credit conversion factor (CCF) up from the 0% (CCF) that applies today.
• Under the ERBA, the risk weight for residential mortgages could rise from its current level of 50% for higher loan to value ratios (LTVs) but would be stratified based on LTV.
• More granular risk weights for exposures to banks, which would be based on a credit risk assessment of the exposure, would be available.
• Publicly traded investment-grade corporate exposures (as determined by the bank) risk weight would decline to 65% from its current 100%.
• The model-based approach for equity exposures would be eliminated, and there would be revisions to the simple risk-weight approach, including removing the 100% risk weight for nonsignificant equity exposures, eliminating the effective and ineffective hedge pair treatment, and increasing the risk weight for equity exposures to certain investment firms with greater than immaterial leverage from 600% to 1,250%.

Below we summarize the risk weights for key credit risk weights as they pertain to the current Basel application standardized approach, proposed Basel endgame charges, and RAC ratio economic risk IV category.

Table 3

Proposed changes to market risk

Currently, a bank calculating market risk capital requirements under the standardized or the advanced approaches generally applies an internal model-based approach, pursuant to which the banking organization uses an internal value-at-risk (VaR) model subject to supervisory approval that is calibrated to a 99% confidence level and a holding period of 10 business days. Additional aspects of market risk capital requirements, such as specific risk, are captured using either models or standardized approaches.

The proposal would replace the current market risk framework with a new standardized methodology for calculating risk-weighted assets for market risk and a new model-based methodology for those banks that opt to use it. The new model-based approach would require a more rigorous regulatory model approval process, which would necessitate approval at a trading desk level. The new model-based methodology would better account for tail risk and would better reflect the risks of less liquid trading positions.

A banking organization calculating market risk capital requirements under the internal model-based approach would use an expected shortfall method calibrated at a 97.5% level in lieu of the current requirement to calculate VaR calibrated at a 99% level, which, according to Basel, is roughly equivalent. In addition, instead of a static 10-day holding period currently employed under the market risk capital rules, the proposal would implement more granular liquidity horizons. The longer liquidity horizons and the more limited use of models will likely result in a significant increase in market risk for banks with large trading operations.

In addition, for certain exposures such as securitization positions and certain equity positions in investment funds, internal models would not be permitted and a banking organization would be required to calculate market risk capital requirements for these exposures under the standardized approach.

Proposed changes to operational risk

Capital requirements for operational risk currently only apply to Category I and II banks, and only under the advanced approaches calculation.

Under the proposal, all banks in scope (Categories I-IV) would be required to calculate operational risk but only for its ERBA risk weights--not its standardized risk weights. The operational risk capital requirements under the expanded risk based approach would be based on a banking organization's business volume and historical losses--a standardized measurement approach (SMA) rather than the current advanced measurement approaches (AMA). The SMA does not rely on a bank's models but instead calculates a bank's operational risk based on its income, expenses, interest-earning assets, and historical losses using a business indicator and an internal loss multiplier. More specifically, the proposal establishes operational requirements through a multistep process. First, a bank measures its business volume over the past three years in three categories: net interest income from financial assets and liabilities, trading activities, and fee income. Those indicators are then subjected to steadily higher multipliers based on the size of each business, such that the larger the business, the greater the requirements. Those figures are then multiplied by an average of the bank's average net operating losses over the previous 10 years, a factor known as the internal loss multiplier. If a Category I or II bank has a solid history of minimal historical losses, it can help buttress its operational risk under the proposal, but only to a degree as this calculation is floored.

Credit valuation adjustment

Credit valuation adjustment (CVA) risk is the exposure to changes in the valuation of over-the-counter (OTC) derivative contracts driven by changes in counterparty credit risk.

Under the U.S. capital rules, capital requirements for CVA risk currently apply only to banking organizations subject to the advanced approaches and only for purposes of calculating advanced approaches RWAs. A banking organization may calculate CVA risk using either a simple CVA approach or, with prior supervisory approval, the advanced CVA approach that uses an internal model.

Under the proposal, Category I-IV banking organizations would be required to calculate capital requirements for CVA risk for purposes of RWAs calculated under the ERBA. As a result, Category III and IV banking organizations, which are not currently subject to the advanced approaches, would become subject to CVA risk capital requirements. CVA risk capital requirements would not be added to the generally applicable standardized approach.

The proposal would eliminate the internal models approach to calculate capital requirements for CVA risk. Instead, under the proposal, a banking organization required to calculate capital requirements for CVA risk would use the basic approach or, with supervisory approval, the standardized approach.

Table 4

Table 5