US Republicans have been clear about what they want regulators to do with controversial proposed prudential rules: go back to the drawing board. But perhaps they need to be careful what they wish for. In practice, a fast track to finalising the US implementation of the Basel III banking standards may require the three federal regulators to scale back their ambitions, which would be more in line with what Republicans and bank lobbyists have been seeking.

Federal Reserve Governor Michelle Bowman, who started her career as a Republican staffer, told a roundtable organised by one of the key lobby groups that she wanted to see a reproposal of the Basel III endgame, which was first aired by the Fed, the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) in July 2023.

“We have to do our homework – prepare proposals that make sense, that don’t have unintended consequences, or at least address those unintended consequences, and bring something together to our board that can be broadly supported,” Bowman said at the Securities Industry and Financial Markets Association roundtable on April 18.

If Republicans were to have control of the House, the Senate and the presidency, it becomes hard for regulators to move forward with a rule that would garner a fair amount of criticism

Republican senate staffer

A current Republican senate staffer says there are similar views on Capitol Hill. And since even some Democrats harbour misgivings about the contents of the initial draft, they think there is a “pretty good chance” of a reproposal. That would likely push finalisation beyond the presidential election in November this year, when a victory for Donald Trump could steer regulatory policy in a different direction.

“Regulators are in a very tough spot – if Republicans were to have control of the House, the Senate and the presidency, it becomes hard for regulators to move forward with a rule that would garner a fair amount of criticism,” says the staffer.

Republicans winning the presidency and control of both houses of Congress is an essential factor, because it opens up the possibility of using the Congressional Review Act. This permits Congress to overturn any major rule under a fast-track procedure, if it was finalised within 100 legislative days of an election. The law was passed in 1996 but used only once until the Trump administration, “when it was suddenly dusted off and used several times”, says a senior regulatory lawyer. The current CRA deadline is May 22, so there is every indication the final Basel III endgame rule will fall within its purview – unless the finalisation is delayed and reproposed well beyond the presidential elections.

That puts pressure on regulators to come up with the bipartisan approach. In testimony due to be delivered to the House Committee on Financial Services on May 15, Michael Barr, the Fed vice-chair for supervision plans to say: “I expect a set of broad, material changes to the proposal that allow us to have a broad consensus in moving the proposal forward.”

And yet, there is growing speculation in the industry that regulators may still seek to finalise the rules without a reproposal. Media reports in recent weeks have floated dates in August or September, and one industry source jokes about a possible Halloween shock, which would mean adopting the final rule just days before Americans go to the polls to elect the president and members of the House and Senate.

Shrink to fit

At first sight, that looks like triggering a direct confrontation between regulators and Republicans. But crucially, fast-track completion might also force the prudential agencies to remove the most controversial parts of the rulemaking. That’s because of a second key piece of legislation – the Administrative Procedure Act (APA) – which requires that if agencies plan such material changes to a rule in response to comments that it is essentially a different rule, then they must repropose it.

“Adding features to the adopted version that were not in the as-proposed version is risky for an agency looking to avoid APA challenge, but if the additions are developments of the proposal – for instance, suggested by commenters – likely the agency is on safer ground,” says Stephen Morris, partner at law firm Katten Muchin Rosenman. “Likewise, pruning back on features of the proposal, particularly in response to comments, is in bounds.”

To devise something that would not provoke Republicans to reach for the CRA, the obvious place to start pruning is on any aspects of the US proposal that go beyond the global standards originally agreed by the Basel Committee on Banking Supervision in December 2017. This would allow regulators to dilute the rules without breaching the international commitments made at Basel.

Adding features to the adopted version that were not in the as-proposed version is risky for an agency looking to avoid APA challenge

Stephen Morris, Katten Muchin Rosenman

“You could probably neutralise a lot of the Democratic concerns and even some of the moderate Republican concerns by doing something much more aligned with Basel as it was proposed, instead of gold plating it,” says the Senate Republican staffer.

Randal Quarles, the former Fed vice-chair for supervision who was appointed by President Trump, warns about the competitive distortion gold-plating can cause for US banks with global operations: “Other jurisdictions around the world that have calibrated their endgame implementation more in the spirit of the Basel agreement.”

Trading desks seek relief

A prime contender for revision – although not exactly a political hot button – is the proposal to impose a credit valuation adjustment (CVA) capital charge on cleared trades. No other jurisdiction has taken this approach, and it is not required in the Basel rules, so it could easily be removed. The Futures Industry Association (FIA) and International Swaps and Derivatives Association have both been lobbying hard for this change.

“The whole point of clearing is that you’re not exposed to the credit deterioration of your counterparty, so there should not be a charge for that,” says Jackie Mesa, head of global policy at the FIA.

Isda is also calling for more granular CVA risk weights for exposures to financial institutions, to differentiate between regulated and unregulated firms. This would involve adding to the Basel III proposal rather than removing elements. However, since Isda suggested the change in its letter responding to the initial notice of proposed rulemaking, the alteration could be deemed the integration of comments from respondents, and therefore consistent with the APA.

The whole point of clearing is that you’re not exposed to the credit deterioration of your counterparty, so there should not be a charge for that

Jackie Mesa, FIA

Lisa Galletta, head of US prudential risk at Isda, says if both these suggested changes are adopted in a final rule, “we’ll see about a 30% decrease in risk-weighted assets for CVA.”

The other candidate for stripping out from the Basel III endgame would be the new market risk framework, known as the Fundamental Review of the Trading Book (FRTB). The Basel Committee itself completed this separately from the rest of Basel III, in early 2019.

Separating and postponing the FRTB implementation could turn the ‘endgame’ into more of a never-ending game. It could also spark concern internationally, because the trading business is probably the most global aspect of banking, where US firms compete directly with European and Japanese systemic banks to make markets. Nonetheless, one industry source suggests a delay could be justified, given that banks’ uptake of internal models to calculate market risk has so far proved lower than regulators had anticipated.

“The issue on internal models adoption is high on the agenda, not only for the US banks, but actually globally,” says the industry source.

Op risk rumble

Another area that has prompted some high-profile criticism is the capital charge for operational risk. Quarles believes the proposed measures “are not well designed” in this area.

“You’ve got too much capital for fee-based businesses that really don’t create a lot of risk,” says Quarles. “For instance, the amount of capital that a wealth advisory business would have to raise would be very significant and inappropriate.”

The issues with op risk capital are not related to gold-plating, however, because the US regulators have stayed close to the original Basel text. Since services such as wealth management do not expose a bank to much in the way of credit or market risk, it is inevitable that they would be disproportionately affected by a new op risk capital framework. Softening the rules would risk the ire of progressive Democrats, at a time when their party still controls the Senate and the White House.

“The research clearly shows there is a lot of risk that was potentially being underpriced in these business lines,” says Shayna Olesiuk, director of banking policy at public interest lobby group Better Markets. “The banks’ side of the argument is that being more diversified is a good thing, but I think that argument breaks down when you see the data that shows just how much risk there is in these fee-based businesses.”

Another industry bugbear is the grossing up of fee revenues in the business indicator for op risk. This could hit clearing services because banks collect fees from clients that are passed straight through to clearing houses, but would still count towards the op risk capital calculation. Again, however, this is not something the US regulators can easily change. It reflects the difference between US Generally Accepted Accounting Principles and the International Financial Reporting Standards used in Europe and elsewhere.

What would be easier to alter is the use of the internal loss multiplier (ILM) that integrates historical op risk losses into the overall capital charge. Although it is part of the Basel framework, regulators have the discretion to set the multiplier at one – something the European Union has already chosen to do. US lobbyists want the Fed, FDIC and OCC to follow suit. 

The senior regulatory lawyer says the ILM makes op risk capital “the real killer” in the US, where fines for misconduct are generally much higher than in Europe. “The operational risk calculation will really punish any bank that has had any kind of enforcement action or fine. And US banks have a much higher proportion of non-interest income than banks in Europe, because US banks are more capital-markets driven.”

The long road

While bank lobbyists seem open to the idea of a quickfire, stripped down version of the Basel III endgame, the Republican party might be less impressed.

“I believe that the level of amendment to the proposal that would be required to make it acceptable will require reproposal, as opposed to going final with changes in light of comments,” says Quarles.

The Republican Senate staffer says the proposal – which was over 1,000 pages long – is so “sprawling” that it is hard to pinpoint and remove individual problematic elements: “It’s become almost toxic and it would be hard to walk back specific provisions at this point.”

Moreover, some of the most politically contentious components would be much harder to tackle by making deletions. The Senate staffer points to the impact on retail residential mortgages, the effects on the primary and secondary mortgage markets, and small business lending as aspects that have riled Democrats alongside Republicans. These elements have also been the subject of a vociferous lobbying campaign by the Bank Policy Institute, which has pulled in bipartisan support and even enlisted help from consumer and social action groups like the National Association for the Advancement of Colored People.

I believe that the level of amendment to the proposal that would be required to make it acceptable will require reproposal

Randal Quarles, former Fed vice-chair for supervision

The impact of the Basel III endgame proposal on mortgage and small business lending is arguably the result of perhaps the most dramatic example of US gold-plating – the decision to scrap internal models for credit risk. But that cannot be solved simply by cutting something out of the existing draft. Instead, it would require large parts of the original Basel text to be added back in.

Defusing this political row would therefore almost certainly necessitate a reproposal. One former FDIC lawyer believes it would be virtually impossible to issue a new proposal before the elections, mainly because it is jointly written by all three prudential agencies.

“Each agency has different constituents and potentially different views of important components of any particular rule, particularly capital rules, so ensuring that the agencies agree on a single component is a long and time-consuming process,” says the former FDIC lawyer. “One can expect that the timing for a major reproposal would drag on for a year or more – I wouldn’t be surprised.”

However, a lengthy delay to the endgame wouldn’t necessarily result in regulators delivering the industry wishlist. Even under a Republic administration, Quarles cannot imagine the US abandoning Basel III altogether. And Fed governors serve fixed terms, so he points out the board doesn’t necessarily witness an immediate transformation in personnel when the administration changes.

Of course, if Joe Biden wins the presidential election, then delaying and reproposing Basel III might not have much impact on the substance of the final rules at all.

Given that possibility, one conservative think-tank analyst has a cynical interpretation of the entire debate. He attributes a lot of the drama to Republican Senator Tim Scott, who he believes is willing to use the threat of activating the CRA as part of a bid for a senior role in a Trump White House. If that’s true, then it is in Senator Scott’s interest for a new US iteration of the Basel endgame to surface before rather than after the election.

“He’ll come out with the CRA and he’s going to get other people who are conservative on board with that,” says the think-tank analyst. “If there’s any reproposal that moves in a good direction, then they will have won, and the industry will look at it as: ‘Great, he was on our side, he pushed, it worked, and we got something that we wanted.’”

Additional reporting by Kris Devasabai. Editing by Philip Alexander