Basel III Endgame (B3E)
On July 27, 2023, the Federal Deposit Insurance Corporation (FDIC), the Federal Reserve Board (FRB), and the Office of the Comptroller of the Currency (OCC) proposed new capital requirements for banking organizations known as the Basel III Endgame (B3E). The joint-agencies’ proposal would extend the application of capital adequacy requirements to banks with $100 billion or more in total assets. Those standards previously only applied to global systemically important banks (G-SIBs).
The changes will expand the requirements for the Standardized Approach and limit the use of bespoke internal model approaches employed by banks, which in some instances lowered their capital requirements. The agencies are seeking to impose uniform modeling standards across large banks and estimated that the overall impact will increase the Common Equity Tier 1 (CET1) ratio by an average of 16%. Those changes could have knock-on implications for impacted banks’ lending and trading activities.[1] Additionally, the B3E proposal would require banks to recognize unrealized gains and losses from their available-for-sale (AFS) securities in their earnings statements. These banks would also be subject to the supplementary leverage ratio and the countercyclical capital buffer, if adopted as proposed.
On October 20, 2023, the agencies announced that they were extending the period for public comment to January 16, 2024, from the original deadline of November 30, 2023. They also extended the deadline for public review and comment to the same date for the proposed change in calculating the capital surcharge for G-SIBs as a result of the efforts needed to generate the requested data to determine compliance with the capital requirements. Multiple industry organizations and political stakeholders have voiced their opposition to the newly proposed regulations. Key objections include the significant increase in overall capital ratios and concerns that U.S. banks will be at a disadvantage compared to their international peers if the proposed regulations are adopted.
Financial Crises Led to Stricter Regulations
Following the 2007-2009 global financial crisis (GFC), the Basel III capital framework was introduced to strengthen regulations, supervision, and risk management across the international banking sector. The framework focused on strengthening bank capital amounts and quality, stricter liquidity measures, and tighter control of derivatives exposures. These regulatory measures were designed to make large financial institutions more resilient in future market disruptions. Higher capital requirements and stricter operational measures that were put in place in the U.S. to clear the Fed's annual stress tests have helped banks to better withstand the headwinds caused by the COVID-19 pandemic. The collapse of Silicon Valley Bank and Signature Bank in March of 2023, however, has prompted regulators to reconsider capital, liquidity, and stress test requirements rules for non-GSIB banks, which are reflected in the B3E proposal.
Implementation Considerations
Following the GFC, the largest US banks, such as JPMorgan Chase, Bank of America, Citibank, Wells Fargo, Goldman Sachs, Morgan Stanley, State Street and BNY Mellon (U.S. G-SIBs), have been working to improve transparency, governance, controls, and regulatory reporting. Starting in 2013, banks were required to share information about their capital adequacy, risk management, and other financial activities in their quarterly regulatory filings. The U.S. Basel III rules set forth the composition of regulatory capital and two methodologies (Standardized Approach and Advanced Approaches) for measuring total risk-weighted assets (RWA). Over the years, these regulatory capital requirements and their complexity have made it time-consuming and expensive for banks to understand, implement, and comply with using the Advanced Approaches for calculating RWA. Developing and maintaining internal risk models, ensuring quality of internal and external data, and ever-increasing computing demands is complex and costly. As part of the B3E requirements, Advanced Approaches that are used to calculate RWAs for credit risk will be replaced with a new expanded risk-based approach.
Two Basel implementation challenges faced by banks and other financial institutions in calculating RWA and capital ratios are:
Setting up an effective governance structure to run a complex RWA program.
Implementing a centralized data repository that can generate financial reports from the data showing compliance with the capital, leverage, and liquidity ratio requirements.
Setting-up an Effective Program Governance
Large banks offer a full suite of financial products and services for their retail, wholesale, investment management, corporate banking, brokerage, and institutional clients alike. To run a successful RWA program, it is critical to set up an effective program governance to ensure all stakeholder groups are included, their roles and responsibilities are identified, and the decision-making process is clearly laid out. The program needs to orchestrate the interaction and integrated delivery among all stakeholders as shown in the governance chart below (Figure 1).
Holistic Data Governance
The second challenge is executing data sourcing, transformation, and quality control. This challenge also includes loading and storing raw and processed data with complex models and risk calculations within a centralized data repository that is accessible to the banks and regulators. The banks need to run their RWA snapshot frequently and produce periodic financial reports from the data showing compliance with the new capital, leverage, and liquidity ratio requirements. The regulators that receive the financial reports from banks also need to have access to the data to verify the results.
Regulators have been keen to enforce their mandates on the banks to establish effective risk management, data governance, and internal controls. Deficiencies in enterprise-wide risk management, compliance management, data governance, and internal controls have resulted in supervisory actions such as Matter Requiring Attention (MRA) notices or Consent Orders (CO). Several banks in the U.S. have been or are operating under regulatory enforcement actions. Data quality and governance have been the source of concerns raised in recent regulatory enforcement actions.
Data quality measures the completeness, accuracy, and timeliness of enterprise data with data moving through hundreds of processes and systems in large banks. Poor data quality is a result of conflicting data and reporting requirements from different jurisdictions, inconsistent data capture and aggregation, siloed legacy databases, and system limitations. In addition, incorrect mapping and transformation logic in data lineage can negatively impact the accuracy of RWA and financial reports.
Even the most sophisticated banks have been challenged with the implementation of these ever-changing compliance requirements, as they were required to produce accurate regulatory reports. For instance, the European Central Bank (ECB) recently fined the European unit of Goldman Sachs 6.6 million euros for credit-risk reporting errors. Goldman Sachs Europe misclassified corporate exposures, applying a lower risk weight and underestimating the RWA. The bank did not detect the mistake in a timely manner because of deficiencies in its internal controls.[2]
Establishing a comprehensive approach (Figure 2) in data quality management and governance in an RWA program is critical. Effective data governance helps banks distribute data responsibilities, attaching data owners to data assets. In addition, proper governance allows teams to visualize where all data lives in the enterprise ecosystem and how they move across the enterprise. Effective data governance makes it easier to plan, implement and monitor preventive and reactive controls to continuously measure and improve data quality for compliance.
A Path Forward
The recent banking crisis has prompted regulators to speed up their demands for tougher capital, liquidity, and stress test requirements for banks. The expected adoption of enhanced capital will increase compliance complexity and increase the bank’s capital requirements. It will also significantly increase the compliance burden for medium-sized banks that have between $100 billion and $250 billion in assets. While some banks are further along in the journey of improving enterprise-wide risk management, data governance and internal controls, other banks will need to make sizeable investments in their enterprise-wide risk and compliance functions. The importance of having an effective program governance and improving data quality and governance for meeting B3E regulatory requirements cannot be overstated.
Sources
[1] Joint Press Release (2023, July 27). Agencies request comment on proposed rules to strengthen capital requirements for large banks, Board of Governors of the Federal Reserve System | Federal Deposit Insurance Corporation | Office of the Comptroller of the Currency, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20230727a.htm
[2] Patrick, Margot (2023, May 15). Goldman Sachs Europe Fined $7.2M for Risk Calculation. Wall Street Journal. https://www.wsj.com/livecoverage/stock-market-today-dow-jones-05-15-2023/card/goldman-sachs-europe-fined-7-2m-for-risk-calculation-errors-Kp5avTuh7k9OaVBoilhz
About Monticello
Bip.Monticello, a member of the BIP Group, is a management consulting firm supporting the financial services industry through deep knowledge and expertise in digital transformation, change management, and financial services advisory. In partnership with Bip.xTech, we collaborate with our clients to infuse the spirit of data-driven organizations and build digital solutions, helping them make their operations more efficient and achieve a competitive advantage in the marketspace.