Preparing for the Basel III Endgame

ISDA Chief Executive Officer Scott O'Malia offers informal comments on important OTC derivatives issues in derivatiViews, reflecting ISDA's long-held commitment to making the market safer and more efficient.

All around the world, banks are getting ready to implement a package of capital requirements for market risk, credit risk and operational risk that will finally complete the Basel III reforms developed in response to the 2008 financial crisis. Within days, US prudential regulators are expected to publish their legislative proposals, following similar proposals in the UK and the EU. As in those jurisdictions, it is critical that the impact of the proposed rules is thoroughly tested and any increase in capital requirements does not disproportionately affect costs for businesses, consumers and investors.

It’s nearly 15 years since the crisis, and the financial system is far safer and more resilient to stress than it was in 2008. In the fourth quarter of 2022, US global systemically important banks (G-SIBs) held roughly $881 billion in common equity tier-one capital, up from $244 billion in 2008, according to a recent PwC report. In the derivatives market, the introduction of central clearing and margining has contributed to a substantial reduction in systemic risk. Nearly 75% of interest rate derivatives traded notional was cleared last year, while $1.3 trillion of margin had been collected by the 20 largest market participants at year-end, according to ISDA research.

Implementing additional capital requirements is a complex challenge. The Basel III regulatory reforms are long overdue, but, as many policymakers have recognized, a further significant increase in capital requirements could have serious consequences. The Federal Reserve has previously estimated that implementing these final measures could result in a capital increase of up to 20% for the largest US bank holding companies, while the Basel Committee on Banking Supervision expects the revised market risk standards will lead to a weighted average rise in capital requirements of 57% for G-SIBs.

An increase in capital for market risk of this size is concerning. Recent periods of stress sparked by the pandemic in 2020 and the invasion of Ukraine in 2022 have highlighted certain liquidity imbalances that may warrant attention, but there has been no evidence that banks were holding insufficient market risk capital to weather those shocks. If banks are forced to ramp up their trading book capital by more than 50%, it could result in higher costs for end users and may force some firms to withdraw from certain businesses.

One of the cornerstones of the new framework is that all banks above a certain size will have to use standardized models to calculate capital requirements for market risk, while the use of internal models will be subject to a much more stringent approval process and ongoing tests that will substantially increase maintenance costs. A recent ISDA survey suggested internal model coverage of bank trading desks would drop from an average of 86% to just 31% as a result of these changes. While the new standardized approaches are more sensitive to risk than in the past, the reliance on a one-size fits-all model will be a major change that could lead to herd behavior and drive concentrations in particular assets.

The publication of the US proposals later this week will be a major milestone that takes us a step closer to the completion of these landmark reforms. It is critical that any increase in capital is carefully considered and based on robust data, and that the overall framework is risk appropriate. We look forward to reviewing the detail of the proposals with our members and sharing our perspective with policymakers in the months ahead.

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