Major regulatory change on the horizon for financial institutions

Although financial institutions have been dealing with the aftermath of bank failures in the first half of 2023, they just received another tidal wave of repercussions, this time in the form of proposed regulations. The industry has been anticipating new interagency proposals, but because bank failures raised urgent questions around both risk management and oversight, the proposals arrived much sooner than expected.

Heightened attention on risk and governance within the banking ecosystem highlights why the recent bank failures will go down in history as landmark events that will permanently change the regulatory landscape.

The Federal Deposit Insurance Corp. has proposed nine rules for financial institutions so far in 2023; several were the culmination of the agency’s work with the Federal Reserve Bank and the Office of the Comptroller of the Currency. (The FDIC has also issued one rule this year that is already in effect and revised another existing rule.)

If finalized, these rules—which are an outcome of the 2023 bank failures—will alter the regulatory environment and be considered one of the key banking developments of this decade. Here’s a look at four of the most significant proposals:

The FDIC, FRB and OCC have proposed changes to capital requirements for large banks (those with more than $100 billion in assets) that aim to improve the resiliency of the financial sector by increasing institutions’ existing capital buffers, making it easier to absorb losses in the event of a failure. The proposed rule—known as Basel III Endgame—would also provide more transparency to the regulatory capital framework that larger insured depository institutions use.

Basel III Endgame has been a long time coming, but of course with the banking turmoil that started in March, the proposed rule made an even larger splash than expected, and not just because the proposal is over 1,000 pages.

The proposal makes a number of changes to the existing framework. Three of highest significance would require institutions to:

1. Include unrealized gains and losses on available-for-sale securities within capital ratios.
2. Meet the supplementary leverage ratio requirement minimum of 3%.
3. Comply with the countercyclical capital buffer, a tool that adds extra capital buffer when the economic market is faring well and releasing the buffer in times of hardship.
    

The first change noted above will have a rather large impact on common equity tier one (CET 1) capital. The rule will no longer allow Category III and IV (those with total assets of $250 billion or more and organizations with at least $100 billion in total assets that don’t fall into categories I-III, respectively) to opt-out of the accumulated other comprehensive income option. Rather, it will require these institutions to recognize most elements (with the exception of the gains and losses that derive from cash-flow hedges) within their capital framework. If implemented immediately, the change is significant, as seen in the graph above. The Q2’23 adjustment would result in a decrease in CET 1 of approximately $129 billion, which would drop the current average CET 1 ratio by 3%.

With these new rules, the agencies are trying to address the issue of consistency across financial institutions, which use a wide range of internal models to calculate their risk-weighted assets. This new standardized approach will help alleviate comparability concerns across institutions, clarify treatment of certain exposures like derivatives and sovereign debt, and overall provide more transparency to the calculations and ultimately to assess capital adequacy.

The agencies will accept comments on their proposal through Nov. 30. Institutions are expected to implement the new framework starting July 2025, but the agencies will allow institutions through June 2028 to fully transition.

Traditionally when it comes to bank failures, the regulators take a purchase-and-assumption transaction approach, typically the least costly option for resolution. But this year’s bank failures posed a new challenge; of the 42 companies (half were financial institutions, the other half were non-bank entities) that were invited to bid on First Republic Bank, only four companies entered a bid. (What’s more is that Silicon Valley Bank only had one viable bid, and Signature didn’t have any.) This market disruption has shown that sizeable failures are not easy to resolve and take much longer to work through than the historical ‘one weekend is all that’s needed’ process.

This shines light on the importance of resolution planning at larger banks, which pose a greater risk in the financial market and could trigger contagion risk if a failure were to occur. The FDIC and FRB have proposed guidance for both domestic and foreign entities, which would require providing a full resolution plan every other year, a full resolution plan every third year or a reduced resolution plan every third year, depending on entity size. This proposal applies to insured depository institutions with $50 billion or more in total assets, however more stringent requirements are in place for institutions sitting above that $100 billion threshold.

To minimize economic disruption, regulators are requiring that institutions consider feedback provided from 2021 resolution reviews alongside incorporating the lessons learned from the 2023 bank failures. Areas of focus may include capital, liquidity, governance mechanisms, and operational capabilities.

One imperative item to consider before creating a strategic analysis is whether your institution will follow a single point of entry strategy, or a multiple point of entry strategy, as the proposed guidance will change dependent on the result.

In addition to this proposed rule for large banks, the regulators released a separate proposal on comprehensive resolution plans, which brings institutions with at least $100 billion in total assets into the spotlight and would require them to submit their plans for review every other year.

This proposal is open for comment through Nov. 30 and is expected to go into effect in 2024.

Under this rule, the FDIC, FRB and OCC for the first time will require financial institutions with $100 billion or more in total assets to maintain long-term debt.

Like the resolution planning rule, the agencies’ aim is to help improve recoverability if a large institution were to fail, and to help the resolution of the failed institution be less burdensome and help alleviate losses incurred by depositors and other creditors.

This rule emphasizes the ability of long-term debt to act as a complex tool and absorb losses if a bank failure were to occur, providing that prioritized financial stability in the market.

As part of its inauguration, the proposed rule will augment loss-absorbing capacity by requiring institutions to maintain, at a minimum, long-term debt that equates to 6% of their risk-weighted assets, 3.5% of their average total consolidated assets and 2.5% of total leverage exposure (if the institution is subject to the supplementary leverage ratio). But the rule will also prohibit institutions from partaking in any transactions that could convolute potential resolution.

The lift won’t be too large based on current financials, as some banks that will be subject to this proposed rule already have enough long-term debt to satisfy the requirements. As of Dec. 31, 2022, average long-term debt as a percentage of risk-weighted assets for institutions with over $100 billion in total assets was 12%. However, when looking at these institutions individually and not in aggregate, current levels indicate that approximately 1% or roughly $11 billion more is needed in long-term debt once this rule has been finalized.