Teh Shifting Sands of Basel III: A US Bank Capital Landscape
The implementation of Basel III in the United States has become a complex and unexpectedly challenging landscape for large banks, notably concerning capital requirements. A key element of this complexity is the “Collins Floor,” a minimum capital requirement enshrined in an amendment championed by Senator Susan Collins. Initially, banks believed they could navigate the new regulations without meaningful increases to their capital holdings, even with the potential loss of internal models for calculating credit risk.
The strategy revolved around the advanced approach to capital calculation under Basel III. Banks with large Significant Capital Buffers (SCBs) reasoned that even without internal models for credit risk, their overall capital requirements under this advanced approach would remain lower than those dictated by the Collins Floor. This meant the Collins Floor would continue to be the binding constraint on their capital. Lobbying efforts focused on maintaining a “dual stack” – both the advanced approach stack and the Collins Floor – believing this offered the most favorable outcome.
However, this carefully constructed plan was upended in July 2023 by Michael Barr, then the Federal Reserve’s Vice Chair for Supervision. while he adopted the lobbyists’ suggestion of retaining the dual stack, he introduced a critical change: applying the SCB to both stacks, effectively replacing the 2.5% capital conservation buffer for banks utilizing the advanced approach.
This alteration dramatically shifted the dynamics. The new advanced approach, dubbed the Enhanced Risk-Based Approach (ERBA) by the Fed, primarily relied on internally modeled market risk. While it also included operational risk and Credit Valuation Adjustment (CVA) – elements not covered by the Collins Floor – unless these latter components were exceptionally small, the ERBA plus SCB was almost certain to become the new, and more stringent, binding capital constraint. This rendered the Collins Floor largely irrelevant.
This shift explains the subsequent call from industry figures like Bessent to eliminate the dual stack. However, removing the dual requirement doesn’t address the core issue: the overall increase in capital requirements stemming from Basel III, particularly the planned removal of internal models for credit risk.Eliminating the ERBA stack is considered unfeasible, as it would remove crucial risk factors – operational risk and CVA – from the US capital framework.
Even if Senator Collins were persuaded to repeal her amendment, it wouldn’t mitigate the broader capital increase. Furthermore, if the Collins Floor were removed, the SCB would likely still be added to the ERBA, maintaining a high capital burden. Simply put, ending the dual requirement addresses compliance costs, but not the fundamental capital impact of the Basel III endgame.
Late in 2024, as Barr’s term neared its end, he proposed adjustments to the ERBA intended to lessen its impact, particularly for cleared derivatives. Though,these tweaks offered limited relief to the largest US banks. The most effective way to moderate the Basel III endgame would be to preserve the use of internal models for credit risk (IRB).
Surprisingly,there appears to be bipartisan resistance to this solution. Barr’s successor, Michelle Bowman, has shown no inclination to reinstate the IRB for credit risk, and recent conversations with bankers suggest they have largely abandoned hope. Consequently, calls to end the dual stack, like Bessent’s, are now viewed as a minor consolation prize in a landscape of significantly increased capital demands.
