Bank Capital, Endgame Edition

New bank regulations would enhance financial stability

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Bankers and regulators are currently fighting over a new capital rule called “Basel III Endgame.” The industry claims that it would be detrimental to the U.S. economy while regulators claim it would improve financial stability. We seek to demystify the technical jargon in order to explain what the proposal is, and what it is not. While the proposed regulation could modestly reduce banks’ returns, it would better protect depositors and the financial system writ large, consistent with the mandates given by Congress to regulators following the 2008 financial crisis.

Regulators aren’t finished yet

In the fifteen years since the 2008 financial crisis, policymakers have substantially strengthened financial guardrails. The Dodd-Frank Act and international capital standards have helped rein in the speculative excesses and consumer abuses that caused the collapse. But the work is not yet complete.

Last summer, U.S. bank regulators proposed a new capital rule—referred to as “Basel III Endgame”—that marks the culmination of the U.S. implementation of the Basel Committee on Bank Supervision’s (BCBS) framework for safeguarding the banking system. In addition to addressing lingering vulnerabilities related to the 2008 collapse, the proposal also begins to correct regulatory weaknesses exposed by three of the four largest bank failures in U.S. history last year. These enhancements to the United States’ bank capital framework are critical for strengthening the largest banking organizations and reducing the likelihood of future financial crises.

Banks are not pleased. Their lobbyists claim that this new proposal would be the death knell of American capitalism. The banking sector insists that increasing capital requirements would reduce lending and impede the United States’ international competitiveness. JPMorgan CEO Jamie Dimon went so far as to warn that U.S. banks would no longer be “investable” if the new capital rules go into effect. So, what’s going on here? Let’s clarify key concepts and rewind the tape.

What is bank capital and why is it important?

As an initial matter, it is helpful to clarify what bank capital is, and what it is not. Contrary to a common misconception, bank capital is not money that is “set aside” or “held” or “locked away in a vault,” unavailable for the bank to use. Instead, bank capital refers to shareholders’ equity that banks redeploy through lending, trading, and other activities. Thus, bank capital requirements establish the extent to which a bank must fund itself through equity rather than through debt, such as deposits. 

Bank capital requirements help safeguard the financial system in three ways.

First, requiring a bank to maintain a capital cushion makes the bank less likely to fail. A bank’s equity is simply the value of its assets minus its liabilities. All else equal, a bigger equity cushion allows the bank to better absorb declines in asset values without becoming insolvent. 

Second, capital requirements help combat the presence of moral hazard in the banking system. Bank shareholders typically have an incentive to encourage risk-taking because at least some of the bank’s liabilities are backstopped by deposit insurance or implicit government guarantees. Requiring the bank to maintain more capital (or equity) means that shareholders have more “skin in the game.” When shareholders have more to lose, they may think more carefully about the consequences of the bank’s actions.

Third, capital requirements help minimize societal costs when a bank fails. If a bank becomes insolvent, the Federal Deposit Insurance Corporation (“FDIC”) must step in to protect insured depositors and resolve the failed bank. This process is easier to execute and less costly to the FDIC when the bank had a larger equity cushion prior to its collapse. The stronger a bank’s capital levels, the less damage gets passed on to third parties if things go south.

How did we get here to this particular regulatory proposal?

The international bank capital framework traces its roots to the 1980s. Developed countries formed the BCBS to establish minimum capital standards and thereby discourage jurisdictions from weakening their domestic rules in a “race to the bottom.” The BCBS produced its first set of standards, commonly known as “Basel I,” in 1988. That initial framework required a minimum capital ratio (i.e., capital to risk-weighted assets) of 8 percent. Under this approach, each asset on a bank’s balance sheet was assigned to a standardized risk-weight category reflecting its perceived risk of default. Cash, for example, was assigned a zero-percent risk weight whereas riskier assets were assigned 20, 50, or 100 percent weights. The riskier a bank’s asset portfolio, the more capital it had to maintain.

Over the next decade, the BCBS began considering revisions to Basel I as financial instruments became more complex and as banks developed their own internal risk models. These deliberations culminated in the issuance of Basel II in 2004. Instead of employing standardized risk weights, Basel II allowed certain large banks to use internal models to assign risk weights to their assets. 

A few short years later—as the United States was still implementing Basel II—the financial crisis struck. Between 2008 and 2012, almost 500 banks failed, and the federal government used $245 billion in taxpayer money to stabilize 700 more. As a result of the meltdown, six million families lost their homes to foreclosure and $17 trillion in household wealth was wiped out. The congressionally appointed panel that investigated the causes of the crisis blamed “widespread failures in regulation.” 

In response to the crisis, policymakers resolved to strengthen the quality and quantity of bank capital. In 2010, the BCBS agreed on an initial set of reforms, known as Basel III, to fix some of the most glaring weaknesses in the capital framework that had been exposed by the crisis. Many developed countries, including the United States, promptly implemented these changes. In the meantime, the BCBS continued working on additional reforms to some of the more complicated elements of the capital framework, eventually issuing the “Basel III Endgame” package in 2017. It is these rules that the U.S. banking agencies are now seeking to implement.

The domestic Basel III Endgame proposal strengthens U.S. bank capital rules in several ways. Consistent with the BCBS’ framework, the proposal reduces reliance on banks’ internal models, which have produced marked variability in risk-weighting for similar assets across different banking organizations. The proposal also better accounts for tail risks faced by banks with significant trading activity, again consistent with international standards. Notably, the proposal would strengthen capital rules for large regional banks with $100 billion or more in assets. This last provision is especially important because the Trump Administration weakened regulatory safeguards for large regional banks, but the March 2023 banking panic demonstrated unequivocally that such firms can destabilize the financial system and must be regulated appropriately.

This is a step in the right direction to protect the financial system

Will the proposal destroy the U.S. economy, as alleged by the industry? Of course not. The new capital rules would not open Pandora’s box, as the financial sector insists, and would instead strengthen the U.S. financial system and the broader economy. Indeed, empirical studies demonstrate that well-capitalized banks lend more throughout the economic cycle than banks with weaker capital cushions. Strong bank capital levels are essential to long-term macroeconomic prosperity and, accordingly, the new capital rules would enhance U.S. competitiveness relative to other countries. So, why are banks unhappy? The financial sector opposes higher capital requirements not because of their broader economic effects, but because requiring banks to maintain additional capital could reduce their return on equity. The banking agencies should focus on protecting depositors and the financial system writ large, consistent with their statutory mandates.