At a Peterson Institute for International Economics event on June 22, Federal Deposit Insurance Corporation (FDIC) Chairman Martin Gruenberg announced that the FDIC — along with the Board of Governors of the Federal Reserve System (Federal Reserve) and the Office of the Comptroller of the Currency (OCC) — will issue an interagency notice of proposed rulemaking seeking public input on how best to incorporate the finalization of Basel III reforms into U.S. capital standards. According to Chairman Gruenberg, a key consideration of the notice will be the scope of application — in other words, which banks will be subject to the Basel III reforms.
Basel III is a set of standards issued by the Basel Committee on Banking Supervision in 2010 aimed at strengthening banks’ capital framework. In 2017, the Basel Committee issued a second set of revisions intended to address weaknesses identified during the financial crisis (the Basel III reforms). The stated objective of the Basel III reforms is to reduce excessive variability of risk-weighted assets and limit the extent to which banks can use internal models to estimate risk to calculate minimum capital requirements.
Chairman Gruenberg laid out four areas of risk addressed by the Basel III reforms:
- Credit risk.
- Basel III introduced a standardized approach for credit risk (which also serves as part of an “output floor” on modelled risk-weighted assets) in place of the model-based approach to enhance transparency and comparability. The Basel III reforms are intended to increase the granularity and robustness of the credit risk capital framework while addressing flaws associated with internal models.
- Market risk.
- The Basel III reforms lead to a fundamental review of the trading book (FRTB), which employs a methodology to capitalize for potential tail risks, using the so-called expected shortfall methodology, as well as market liquidity risk under stressed conditions. The FRTB also sets out more stringent requirements for the use of internal models for calculating capital requirements and introduces a standardized measurement for market risk that provides a more consistent approach to calculating capital requirements.
- Operational risk.
- The Basel III reforms replace the model-based approach with a standardized approach that is adjusted for banks’ own historical loss experience and displaces reliance on internal models, which — according to Chairman Gruenberg — has resulted in a lack of transparency and comparability.
- Risk associated with financial derivatives.
- Due to the impact to the banking system from losses associated with derivatives activities during the Great Recession, Basel III introduced a capital requirement for potential changes in the value of derivative instruments as a result of the deterioration in the credit worthiness of a counterparty. The Basel III reforms improve the estimation of credit valuation adjustment risk by introducing frameworks consistent with the more robust methodology under the revised market risk framework.
The FDIC, Federal Reserve, and OCC are considering whether to apply the Basel III reforms to banks with assets over $100 billion. This consideration has been influenced by the recent failures of three institutions with assets between $100 and $250 billion. According to Chairman Gruenberg, “[i]f we had any doubt that the failure of banks in this size category can have financial stability consequences, that has been answered by recent experience.” Before these recent bank failures, the banking agencies had planned on applying Basel III to only the largest banks.