On July 27, 2023, US federal banking regulators issued proposals to (i) significantly revise the riskbased regulatory capital requirements for certain midsize and larger US banking organizations (the "Capital Proposal"), and (ii) change the method for calculating the capital surcharge for globally systemically important banking organizations ("G-SIBs") (the "G-SIB Surcharge Proposal").1 These proposals are of critical importance because the amount of capital a bank must maintain with respect to any particular loan, investment or activity is typically a significant - if not the most significant - factor in determining whether the relationship is profitable or even feasible.2 Comments on both proposals are due by November 30, 2023.

The Capital Proposal would apply to any banking organization with $100 billion or more in assets, as well as others with significant trading activity, and would significantly increase the capital requirements for most institutions.3 This would cover the 8 US G-SIBs, approximately 22 larger and midsized US banking organizations (ranging from traditional regional banking organizations to credit card and other niche organizations), 10-12 US intermediate holding companies of foreign banking organizations, and 7-10 other US banking organizations. It would not directly affect credit unions, US branches and agencies of foreign banking organizations, or the non-US operations of foreign banking organizations.

The Capital Proposal would make material changes to the calculation of risk-based capital requirements and expand the range of risks for which capital must be held. Although the Capital Proposal is intended to implement 2017 changes to international capital standards (the "Endgame Standard") adopted by the Basel Committee on Banking Supervision ("Basel Committee"), US regulators have made significant changes that expand the range of institutions covered by the Capital Proposal and impose more stringent requirements than those adopted by the Basel Committee. Further, while US regulators initially signaled that capital levels would not be materially impacted by the Endgame Standard, the Capital Proposal is now expected to increase common equity Tier 1 ("CET1") capital by around 16% for banking organizations subject to the Capital Proposal.4

As discussed below in more detail, most importantly, the Capital Proposal would:

  1. Replace the advanced approaches for credit risk with an "expanded" standardized approach that is a more stringent version of the Endgame Standard.
  2. Require these banking organizations to calculate their risk-based capital ratios under the existing standardized approach and expanded standardized approach (a "dual-stack" requirement), and use the lower (less favorable) ratio of the two.
  3. Result in an overall increase in the market risk capital requirements and impose stricter requirements for using models in order to calculate market risk.
  4. Replace the model-based approach for operational risk with a standardized framework for operational risk capital.
  5. Eliminate the opt-out for accumulated other comprehensive income ("AOCI").
  6. Apply these revised capital requirements to all banking organizations with $100 billion or more in total assets.
  7. Impose an output floor that would limit the amount capital calculated with internal models could deviate from the expanded standardized approach to 72.5%.

The release of the Capital Proposal was marked by significant dissents by principals of the FDIC and Federal Reserve. At the FDIC, Vice Chair Travis Hill and board member Jonathan McKernan voted against issuing the Capital Proposal and issued strong statements sharply critical of the Capital Proposal, particularly the deviation from the Endgame Standard. Similarly, Federal Reserve Governors Michelle Bowman and Christopher Waller voted against issuing the Capital Proposal and raised concerns about the potential economic impacts of the Capital Proposal. Although Federal Reserve Chair Jay Powell and Governor Philip Jefferson voted to issue the Capital Proposal, each made statements indicating concerns about its potential effect and signaled that they would be looking to make changes to the Capital Proposal. Of potential significance, the day after the Capital Proposal was issued, the US Senate initiated the process for confirming Dr. Adriana Kugler to be a governor on the Federal Reserve Board. If confirmed, Dr. Kugler could provide an important vote for finalizing the Capital Proposal.

A rare lack of consensus among the principals of the FDIC and the Federal Reserve regarding the Capital Proposal raises the prospect that material changes could be made before it is finalized. The prospect of changes could be further increased as Congress has already requested that US banking regulators testify about the Capital Proposal due to concerns about the adverse potential impacts of the Capital Proposal on the economy, financial markets, and lending.5 Due to the lack of consensus among banking regulators, the substantial public interest in the Capital Proposal and the 120-day comment period plus the time the regulators will need to consider the numerous filed comments, it is likely the Capital Proposal will not be finalized until well into 2024 at the earliest.

If adopted in its current form, the Capital Proposal could have a considerable impact on the operations of banking organizations subject to the Capital Proposal and on the overall US banking industry. To start, the Capital Proposal would require banking organizations to substantially increase their capital levels from a combination of retained earnings, new equity issuances, or a reduction in assets. In addition, midsize banking organizations that have not been subject to sophisticated capital requirements would need to adopted more advanced capital operations and strategies. This would go beyond mere calculation of capital and include also include creating new securitization structures, issuing new types of capital instruments, and identifying alternative funding sources.6

The Capital Proposal's increases in capital requirements would also increase the costs of bank lending and trading activities, driving some of these activities to nonbank financial institutions, or increasing the costs for customers and counterparties in the Main Street economy. These costs could be particularly impactful for midsized banking organizations that had not previously been subject to advanced capital requirements. Accordingly, the increase in capital requirements and the costs associated with them could intensify already-existing pressure on smaller affected banking organizations to become larger, including through mergers, in order to spread the costs over a large asset base. Given the Biden Administration's focus on antitrust, it is curious that the Capital Proposal does not discuss its potential impact on market concentration.7 From an international perspective, the Capital Proposal could reduce the competitiveness of US banking organizations versus banking organizations from jurisdictions with less punitive capital standards, including the Endgame Standard, potentially limiting international engagement by US banking organizations and a further reduction in foreign bank participation in the US market.

The Capital Proposal would also materially impact banking organizations with significant fee income operations as it includes new operational risk capital charges that are based, in part, on the amount of fee or commission-based income, including fiduciary and custody services, loan servicing, securities brokerage, investment banking, advisory and underwriting, and insurance. The Capital Proposal also would disproportionately impact banking organizations that are credit card issuers or have significant amounts of low-risk assets, including noncontrolling investments in US nonbanking companies, which are common among foreign banking organizations.

The G-SIB Proposal would significantly impact banking organizations with substantial cross-border activity, particularly foreign banking organizations that control larger US banking organizations. Although the stated intent of the G-SIB Proposal is to improve the "precision of the G-SIB surcharge," the changes to the calculation of the cross-jurisdictional activity indicator to include derivatives exposures would cause nine banking organizations or their intermediate holding companies to shift into Category II from Categories III and IV for purposes of the enhanced prudential standards. In addition, because US regulators made significant deviations in the Capital Proposal from the Endgame Standard, the Capital Proposal would effectively impose higher costs on banking organizations based, or operating, in the United States.

However, there could be some winners under the Capital Proposal, although not necessarily those who the banking regulators intended. The Bank Policy Institute noted in response to the Capital Proposal that "private equity, private debt, hedge funds, finance companies and other unregulated firms" would likely gain market share with higher margins.8 These entities also may find opportunities to help banking organizations directly by facilitating transactions that reduce risk (e.g., credit risk transfer trades), acquiring credit exposure through securitizations and commercial paper conduits, and purchasing assets or activities that incur high capital charges but do not need to be held by, or undertaken in, a banking organization (e.g., certain payment card activity, investment banking, and derivatives dealings). Within the US banking system, there are likely to be competitive shifts as banking institutions that do not engage in activities most impacted by the Capital Proposal (e.g., trading activities, fee or commission-based activities) benefit on a relative basis as the Capital Proposal would have more impact on their competitors.

In this Legal Update, we provide background on the regulatory capital requirements, discuss the Capital Proposal and G-SIB Surcharge Proposal and highlight a number of the likely potential impacts.

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Footnotes

1. FDIC, Board Meeting (July 27, 2023), https://www.fdic.gov/news/board-matters/2023/board-meeting-072723-open.html; Federal Reserve, Board Meeting (July 27, 2023), https://www.federalreserve.gov/aboutthefed/boardmeetings/20230727open.htm. The US federal banking regulators consist of the Board of Governors of the Federal Reserve System ("Federal Reserve"), Office of the Comptroller of the Currency, and Federal Deposit Insurance Corporation ("FDIC").

2. See, e.g., Michelle Bowman, Responsive and Responsible Bank Regulation and Supervision (June 25, 2023) ("Banks pursue business strategies and offer products not despite capital requirements, but with the full knowledge and understanding of the capital allocations required to engage in that activity.").

3. US banking organizations include national banks, state member and nonmember banks, federal and state savings associations, top-tier bank and savings and loan holding companies domiciled in the United States that are not subject to the Small Holding Company Policy Statement, except certain savings and loan holding companies that are substantially engaged in insurance underwriting or commercial activities, and US intermediate holding companies of foreign banking organizations.

4. For Category I and II banking organizations, Tier 1 capital requirements would increase by an estimated 19%; for Category III and IV US bank and savings and loan holding companies, an estimated 6%; for Category III and IV US intermediate holding companies of foreign banking organizations, an estimated 14%.

5. Letter to The Honorable Michael Barr from Chair Andy Barr and Ranking Member Bill Foster of the House Financial Services Committee's Subcommittee on Financial Institutions and Monetary Policy (July 7, 2023); see also Letter to The Honorable Jerome Powell from Ranking Member Tim Scott and each Republican member of the Senate Banking Committee (July 21, 2023).

6. See our recent article discussing one of these alternatives: https://www.mayerbrown.com/en/perspectives-events/publications/2023/05/residential-mortgage-loans-capital-relief-through-synthetic-securitization.

7 See also our Legal Update on this antitrust focus: https://www.mayerbrown.com/en/perspectives-events/publications/2022/04/us-fdic-requests-comment-on-bank-merger-oversight-framework.

8. Press Release, BPI Response to Banking Agencies' Basel Proposal (July 27, 2023).

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