How Low Capital Requirements Could Go Under President Trump

Amid continuing deregulatory activity under President Trump, this summer has included several noteworthy developments on the capital requirements front. In June, Federal Reserve Vice Chair for Supervision Michelle Bowman and leaders at the FDIC and OCC proposed a decrease in the enhanced supplementary leverage ratio (eSLR) that is based on the tier 1 capital at the largest banks. Since then, the Fed has hosted a conference on the capital requirements framework as part of a process led by Bowman to design an overall plan to simplify capital requirements, including reconsideration of a proposed Basel III Endgame calculation.  

At one point under former President Biden, the Fed suggested a 19% average increase under Basel III Endgame. Now, in the current deregulatory environment, requirements could decrease. In the following interview with Douglas Elliott, a partner at Oliver Wyman focusing on financial regulation and associated public policy, Elliott explains where capital requirements stand and where they could be headed. (Spoiler: He envisions a reduction overall of 5% to 15%, but read on to see what could determine where the figure ultimately falls.)  

RMA JOURNAL: Can we start with a high-level view of where we stand today regarding Basel III Endgame and the forces at play regarding capital requirements?

ELLIOTT: Capital is an important subset of a larger ideological division between the Democrats and Republicans. They simply have different political philosophies of financial regulation. As a general rule, Democrats would like to buy more financial stability insurance. They’d like higher capital requirements to provide more protection, while recognizing that has a cost to the financial sector and to some extent the whole economy. The Republicans have generally not wanted additional insurance and in fact many believe we are overprotecting the financial sector—that you could pull back on capital and some other requirements and still have a very safe sector. So, it’s not a surprise that when party control flips, you see pretty big moves on capital requirements. The new team is trying to look holistically at all the things that might make sense to change. Basel III Endgame has gotten a lot of attention in recent years, for good reason. But I think it’s going to turn out to be significantly less important than some other factors taken together.

RMA JOURNAL: Why is that?  

ELLIOTT: There’s a limit to how much the change in aggregate capital requirements will come from Basel. The original proposal, introduced by regulators in July 2023, was something like a 19% aggregate increase. That just wasn’t going to fly considering extremely strong and effective opposition from the industry and others. So then last year Michael Barr [who was replaced earlier this year by Bowman as vice chair for supervision] floated a proposal where the aggregate effect would have been more like a 9% increase. However, the Republicans and the new team that has taken charge are not interested in going nearly that high.

RMA JOURNAL: Can you explain the eSLR and the recent Fed proposal regarding it?

ELLIOTT: The eSLR applies to the largest banks and requires them to meet a higher standard than the 3% leverage requirement that applies globally under the Basel capital standards. It’s about a 5% requirement for the largest institutions, and a 6% requirement for the insured depository institutions within these groups. Those are big numbers and the Department of Treasury and the new team have concluded that this has been making it harder for banks to fully participate in the Treasury bond market and in market-making on safe assets in general. The proposal is to change the formula for the eSLR and make it 3% plus half of an individual banking group’s GSIB surcharge as calculated under the approach used globally. That would add, at most, about 1.25% to the 3% base, putting the highest eSLR number at 4.25%—lower than the 5% and 6% at present.

A second part of that proposal would exclude from the calculation Treasurys held by banking entities for market making. The leverage ratio changes are intended to prevent the leverage ratio from being a binding constraint on capital use. It will be there as a backstop in case other requirements end up being ineffective. For example, if risk weights are systematically underestimated, there’s some value in having a leverage requirement.

RMA JOURNAL: What are the other factors that could affect capital requirements?

ELLIOTT: There’s the CCAR stress test. The industry is suing the Fed over it on the grounds that the transparency requirements of the Administrative Procedure Act haven’t been met. The industry will win this case, and the Fed knows the industry will win. The question then would be what a judge would decide are the proper remedies. Neither the industry nor the Fed particularly wants a judge deciding this, so they are in the process of negotiating a settlement. In theory, the transparency requirements might not change capital requirements: The test could end up involving the same processes, but everybody would understand it better and have more chance to comment.

I think there are reasons why, in practice, capital requirements will be reduced regarding stress testing. First, the Fed, knowing it will have to circulate detailed models and scenarios for comment, is likely to take away some of the conservatism they would otherwise have put in because they may find it hard to defend. Even considering that, the comments that come back will be overwhelmingly about items where the industry thinks that there’s still too much conservatism. I think the new team will want to respond to some of those comments by making changes, and directionally that will be toward lower capital requirements.

Second, the stress test-based capital requirements currently don't come from the models that the banks run based on the instructions from the Fed. Because the Fed is aware that the models leave room for implementation differences across the banks, and indeed for gaming the system, the Fed runs its own, somewhat more simplified, model. They’ve tended to believe their model more than the straight output from the banks and therefore they’ve required higher capital than the bank models calculate. Let me stress that the bank models are based on detailed requirements from the Fed. It’s just that this is all very complicated and there is room for interpretation. But I think in practice there’ll be pressure on the Fed to not vary too far from what comes out of the bank-run models.

The third consideration is the GSIB surcharge, which I mentioned briefly earlier. The Fed said 10 years ago, when they first put the surcharge methodology in place, that they would periodically adjust the thresholds for moving to a higher capital charge based on growth in the industry, inflation, etc. They haven't done it, but it’s clear that the new team wants to.  In fact, even under the Biden administration, then-Vice Chair Barr raised the likelihood that they would adjust these thresholds based on growth. Doing so could be significant. My colleagues at Oliver Wyman have run the numbers. If you just based it on general inflation and didn't change anything else, it would be about an 8% reduction in total capital requirements for the GSIBs. 

And that does not account for the fact that there are two methods to calculate how systemically important you are—and therefore your surcharge. The rest of the world uses so-called Method One. But the U.S. felt this wasn’t tough enough so went with Method Two, which has consistently been significantly higher. This is now under review. A rough calculation we did suggested that moving from Method Two to Method One could bring a roughly 13% decline in total capital requirements for the largest banks. So, we’re talking about pretty big numbers.

When you take all these things together, I think you'll see somewhere between a 5% and a 15% reduction in capital requirements for the largest banks compared to when President Trump took office.

RMA JOURNAL: It sounds like the ultimate numbers could be higher, based on all the possible adjustments you have cited.

ELLIOTT: It’s true that if you add everything up, you could get to a 30% or higher reduction to capital. But there’s no way that even the new team wants to go that far. That‘s why I bounded it at 15%.   Because the bottom-up approach could bring bigger changes than the new team wants, they might allow the Basel III Endgame to push up capital requirements a bit, but not to anything near the compromise 9% proposal, to somewhat offset some of these other changes. Beyond that, they may hold down the scope of the other reductions to stay within this range.