5 Takeaways from Greg Baer’s Testimony on the Basel Capital Proposal

BPI President and CEO Greg Baer testified today at a House Financial Services hearing titled "Prioritizing Main Street: Evaluating the Impact of Capital Proposals on Economic Growth and American Communities." Baer discussed the U.S. banking agencies' recent capital proposals, the interactions between different elements of the capital framework and the effects on the economy and the financial system.

Here are 5 takeaways from the hearing:

1. The revised Basel proposal more accurately captures risk, leading to more efficient capital allocation.

Rep. Bill Huizenga (R-MI): Mr. Baer, I want to ask you. How do these revised risk weights improve the accuracy of capital allocation across different types of exposures? … how does that translate into safer and more efficient flow of credit to households and businesses?

Greg Baer, BPI: Sure, thanks. A central feature of Basel is the new, expanded risk-based approach. I mean, that is a more granular look at risk. It differentiates into more risk buckets. So, for example, it considers the loan-to-value ratio on mortgages, which previously was not a consideration, they were all in the same bucket. So, by doing that, I think you'll see greater granularity, there's greater accuracy and more efficient capital allocation.

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Rep. Bill Huizenga (R-MI): So do you expect this to reduce the likelihood of risk being underpriced in certain asset classes, as we saw in the lead-up to the financial crisis?

Greg Baer, BPI: Clearly. I mean, the central challenge of capital regulation is how detailed you want to get. If it's too detailed, it's basically the government setting the terms of loans. But also it's incredibly burdensome and complicated. On the other hand, you don't want to do what Basel I did, which was just establish a few general risk buckets and treat all corporate loans the same, all mortgage loans the same. I think here, the agencies struck a good balance where they have a standardized approach that is more risk-focused, more granular, but then they also have, in the United States, a stress test that will give you a good look at risks in each bag.

2. Fed Chair Powell referred to bank capital as "about right" in 2019 - since then, capital has increased significantly.

Greg Baer, BPI: I'd just add one other thing. I thought it was helpful that you noted that Chair Powell had said that capital was about right. The Committee might want to know he first said that in 2019. Since 2019 capital has increased 8% for the GSIBs and the Category II banks, 6% for the Category III and IV banks. So this proposal, which only lowers it 4.8% for Category I and II, 5.2% for III and IV, still would have us significantly higher than it was when it was about right.

3. The Fed has rightly acknowledged there is work to be done regarding overlap in the Basel proposal and the stress tests.

Rep. Dan Meuser (R-PA): Mr. Baer, another concern with Basel III Endgame has been its overlap with the stress tests, particularly around operational risk. How do you believe the Fed has addressed this overlap? Does operational risk remain the primary driver? Are there still areas where the proposal could be improved?

Greg Baer, BPI: The one thing they've done is acknowledge that there is an overlap which previously had not been acknowledged. I think Luigi described pretty well the overlap on operational risk, where that was not previously part of the standardized approach. So the Fed put it in the stress test, and now they've added it to the standardized approach, and it's being counted twice. The equally important one, and vastly more complex, is market risk, or somewhat similarly, the Basel 2.5 basically used a value at risk methodology to check on market risk, which basically looks at the most common occurrences, but not the tail risks. The Fed in response to that said, you know what we're going to run a global market shock. We're going to assume the worst of the worst. We're going to capitalize for the tail. That made sense, so Basel was business as usual. That stress test was catastrophic risk. But now they are updating the Basel proposal now with what's called the Fundamental Review of the Trading Book, and that is also going into the tail. So now we're, we're twice into the tail, as it were, and that's something that needs to be rationalized. Again, it's very helpful that they've acknowledged that it's incredibly complicated how to rationalize those two things, but I think they're working on it.

4. The banking agencies should carefully tailor requirements to account for economic growth and institutions' differing risk profiles.

Rep. Scott Fitzgerald (R-WI): Thank you, Mr. Baer. I just have a minute here. One concern has been addressed again a couple times. One of the concerns with 2023 Basel proposal was the lack of, I guess, appropriate "tailoring" might be the way to describe it. How do the revised proposals better account for the difference in size, complexity and business models?

Greg Baer, BPI: Sure, for the smallest banks, separate from this proposal, there's been a lowering of the Community Bank leverage ratio that community banks can opt into. There's a legacy standard size that would be it would apply. It does not apply to GSIBs, but could apply to all their banks, and they have reduced some of the risk weights there, and then all any bank will also have the option into the expanded risk-based approach and get those better risk weights. But I would note there was another tailoring issue that's not an issue here, which is important, which is the years after the global financial crisis, there were various thresholds set for heightened super set for heightened supervision. There are probably more than a dozen of them. I have a chart. Those need to be indexed for GDP growth. I think the agencies probably are on path to doing that. They've had a lot of work to do recently, but it is really important for midsize regional banks that they not be continued to be treated like banks much larger than simply because the economy's grown and they've grown along with it.