Proposed Capital Rules Could Crimp Credit Card & Mortgage Lending

Colored by the regional bank failures of early 2023, a new set of capital rules proposed by federal regulators could change the dynamic in credit card and mortgage lending. Beyond the product-level impact, the proposal could slam regional banks when they are already hurting.

In July, federal banking regulators issued a notice of proposed rulemaking intended to “increase the strength and resilience of the banking system” by making the capital rules for large U.S. banks more risk sensitive and consistent across firms.

The proposed rules would have a significant impact on the competitive picture for banking.

The agencies estimate the modified rules would require large banking organizations to hold in aggregate 16% more capital than required under current rules. If adopted, the new rules could materially alter the economics of lending, particularly for the largest banks and those heavily concentrated in certain activities.

Why Are Regulators Proposing Changes to the Capital Rules for Large Banks?

The proposal is the culmination of over a decade of capital reforms developed in coordination with international regulators in response to the Great Financial Crisis.

A bit of background: The standards are known as “Basel III” because they were issued by the international Basel Committee on Banking Supervision as part of the third international accord for strengthening global banking regulation. The initial Basel III standards were published in 2010 and gradually implemented in the U.S. over the last decade.

In 2017, the committee issued significant updates to the international standards, which many now refer to as the Basel III “endgame.” The current proposal from U.S. regulators is intended to generally align with those updates and includes other targeted changes to the capital framework for large banks.

Stress-Induced:

The endgame regulations were anticipated, but the proposal issued in July 2023 was heavily influenced by more recent events — most notably the regional bank failures in the spring and industry stress that followed.

For instance, in prior years, regulators routinely signaled that the endgame rules would only apply to the largest, most internationally active banks. However, as proposed, the rules would apply to all banks with at least $100 billion in assets. That includes regional banks that just a few years earlier had been targeted for capital relief due to their lower complexity and risk profile. It’s no coincidence that Silicon Valley Bank and Signature Bank were both part of that cohort.

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How Would Bank Capital Requirements Change Under the Proposal?

The proposal would modify core aspects of the capital rules applicable to large U.S. banks, collectively increasing the stringency, granularity and consistency of the requirements and applying them to more banking organizations.

Key changes include:

• More Standardization: The proposal would greatly reduce the extent to which some large banks are permitted to use their own internal risk models to size exposures for purposes of calculating their capital requirements.

To promote consistency and comparability, all banks subject to the new rules would be required to calculate their risk-weighted assets (i.e., exposures against which capital must be held) using a new “expanded risk-based approach” that incorporates standardized measures for credit risk, operational risk, market risk and credit valuation adjustment risk (i.e., counterparty risk associated with derivatives). Although some banks may be permitted — with agency approval — to use internal models to calculate market risk exposures, the standards for obtaining such approval would be significantly more stringent than under current rules.

• Higher Risk Weights: Overall, the agencies estimate the proposed rules would increase the amount of risk-weighted assets for covered holding companies and their depository institution subsidiaries by 20% and 9%, respectively. The impacts would vary significantly across firms, depending on their activities and risk profile.

• Expanded Application to More Banks: The proposal would effectively undo core aspects of the Federal Reserve’s “tailoring rules” adopted in 2019. The proposal would do so by applying heightened capital standards currently reserved for banking organizations in the highest risk tiers to all banking organizations with at least $100 billion in assets.

For example, certain banking organizations would no longer be permitted to disregard unrealized losses in their securities portfolios when calculating their capital ratios. This is a clear response to the failure of Silicon Valley Bank.

Such firms would also become subject to new requirements to calculate risk-weighted assets for operational risk, market risk, and derivative exposures, as well as other capital rules currently only applied to the largest U.S. banks.

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How Would These Changes Impact Banking Activities?

Precisely how conditions will change is uncertain. The banking agencies publicly acknowledge that higher capital requirements may result in reduced lending and market liquidity. However, they believe those costs would be outweighed by the increased resilience of the banking system.

On the other hand, large banks and their trade associations argue that existing large bank capital rules are more than sufficient. They say the proposal would unnecessarily constrict bank lending, harming consumers and small businesses, and lead to continued migration of financial activity into unregulated parts of the financial sector.

Some of the more significant potential implications worth considering include:

Altered Loan Economics: Lending activity creates risk-weighted assets. That, in turn, determines the amount of capital that must be allocated to support that activity.

Changes to risk-weights for different types of loans can therefore influence banks’ portfolio allocation decisions. An increase in risk-weights for a particular product may cause banks to reduce originations of that product and shift to less capital intensive activities. The regulators acknowledge this effect, but estimate the overall impact would be “modest” with banks’ portfolio allocations only changing by a few percentage points.

However, the impacts will be uneven across asset classes and economic considerations would meaningfully change for certain products. To illustrate, consider the following products:

Credit Cards. Two changes to the risk weighting for credit card exposures could have meaningful impacts on the market for those products. The proposal would introduce differentiated risk weights based on whether a customer pays their balance in full every month (a “transactor”) or periodically carries a balance on their card (a “revolver”).

The higher risk weighting required for revolvers may lead issuers to reconsider how their products are designed, including eligibility terms, pricing, reward programs and other incentives.

The proposal would also require banks for the first time to calculate risk-weighted assets for a portion of the credit card line that is not utilized by the cardholder. This may make banks think twice about offering generous credit lines with no annual fee.

Residential Mortgages. The proposal would use the loan-to-value ratio of a residential mortgage at the time of origination to determine its risk weighting. Higher LTV loans would see significant increases in risk weighting. Such loans happen to be a segment of the mortgage industry that still relies heavily on banks for financing. This has understandably led many industry observers (including consumer groups and even some regulators) to worry about the adverse impact it might have on the availability of lending to first-time home buyers and low- to moderate-income consumers.

There are also concerns about the proposal’s impact on banks’ willingness to continue servicing mortgage loans, a role that has already seen significant migration to less regulated companies driven in part by regulatory capital considerations.

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What Does This Mean for Regional Banks?

The regulators’ proposed rules would also affect banks as business entities:

• Hitting regional banks while they are down. The proposal comes at a time when headwinds are already blasting the banking industry, and in particular regional banks.

The agencies’ decision to apply the new rules to Category III and IV banks, many of which have comparatively simple domestic-focused operations, would be yet another blow to the sector. The smallest Category IV bank is less than 3% the size of the largest Category I bank.

Merely building out the processes to calculate and reliably report capital and risk-weighting under the new standards will be a costly undertaking. In order to build the additional capital necessary to support the higher risk weightings, some banks will also likely be forced to curtail capital distributions for a period of time.

Regional institutions are also inherently more concentrated in certain asset classes, so the uneven impacts of the rule may be more significant for some banks.

But Wait, There's More:

Regulators are signaling imminent changes to other potentially costly rules such as enhanced liquidity standards, total loss-absorbing capital, resolution planning, and higher FDIC insurance assessments.

Needless to say, the timing is not great for regional banks already beset by stresses to their business from factors such as interest rate risk, higher funding costs, credit quality concerns, and rating agency scrutiny.

• Bank merger activity will be affected. By eliminating differentiation across regulatory tiers for banks with more than $100 billion in assets, the proposal would remove one of the more significant regulatory disincentives for large bank mergers.

At the same time, a new regulatory “cliff” would be carved at $100 billion that would likely chill desire for mergers among midsize banks that could benefit greatly from additional scale.

More megabank mergers and more stagnation among the thousands of smaller banks already struggling to compete is hardly in step with the prevailing policy priorities of the day.

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Looking Ahead, What Should Banks Do About the Proposal?

This only scratches the surface on the myriad consequences that the proposed changes to bank capital standards might have on the banking industry and broader economy.

As with any rulemaking, regulators have encouraged interested parties to provide comments that will be considered when they craft the final rule.

The proposal includes 176 discreet questions, which is a clear sign the agencies are eager for feedback and not at all dug in on the path they’ve chosen. The proposal was not approved unanimously and even those who voted in favor have voiced concerns about striking the right balance. It appears there is genuine opportunity for the public to weigh in and help the agencies get things right.

The deadline for submitting comments is Nov. 30, 2023.

About the author:

Patrick Haggerty is senior director at Klaros Group.

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