Public Funds Investment Institute

Basel III Endgame Could Change the Playing Field for Public Funds Investors

February 20, 2024

Opposition to the Basel III Endgame capital rules proposed by the federal bank regulators has intensified as the public comment period ended in mid-January, with new  TV ads criticizing the proposal,  a blizzard of comment letters  filed with the regulators, and a flurry of Congressional hearings to warn of  harm to bank lending  if the rules are finalized.

Warnings about lending and credit make good headlines but beyond the headlines potential effects on bank operations and financial markets just as important for public funds investors.

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Let’s take a look. At the most basic, the Basel III Endgame rules focus on the amount of capital that banks must have to support credit and lending activities. The banking industry, led by an organization of large banks and the American Bankers Association, has focused on the effects the rules could have on lending. They have been joined by  some business lobbyists and consumer groups concerned that the rules will a) rise the cost of borrowing, b) reduce the availability of credit, especially for smaller businesses and emerging economic initiatives like green energy investment and c) advantage non-bank institutions (think Rocket Mortgage or Quicken Loans)  that will not be subject to the rules.

The regulators and some economists have pushed back.

The dialogue goes something like this:

Banking interests argue that the US financial system is sound. They point to the fact that it responded well to the Covid-19 disruptions, all things considered, and to the bank crisis around the failure of Silicon Valley Bank last year. Regulators say “yes, but when the markets nearly froze during the Covid lockdown we stepped in to implement extraordinary measures to support the markets, we cut interest rates to zero, and last year we bailed out all depositors in failed banks.”  To which banking interests respond, “But this didn’t cost the taxpayers anything; in fact, the bank bailout was financed entirely by a surcharge on bank insurance premiums that we paid.”

The banking interests say, “You haven’t presented a comprehensive cost- benefit analysis.”  To which the regulators respond, “A cost-benefit analysis would not capture the social costs of market instability or a systemic failure.” 

What about operations and market-making? The focus has been on lending because that captures the public’s attention, but the rules also would require that banks consider risks related to operations (think payment services and custody) and market activities (trading and financing). It could lead to their allocating a lot more capital to these activities. (The Bank Policy Institute claims that the proposal would require a 70 percent increase in capital required for market trading.)  Capital has a cost and allocating more capital could raise the cost of operations and market-making, resulting in higher fees and less service.

The potential impact on operations and market-making has gotten the attention of some commentors who normally stay out of the wrangling between banks and regulators about capital requirements. The investment Company Institute filed a comment expressing concern that the proposal “fails to explore the potentially detrimental consequences to market liquidity and market-making of imposing higher or ill-conceived capital standards on banks. . ..” (See ICI Comment letter here.)

Banks currently recognize capital costs associated with operations and market activities, largely by relying on their internal business models. If they were required to apply industry-wide metrics such as those in the proposed rules, some might step away from portions of these businesses while others could up what they charge for operations-based services or market-making.

Dealers might hold fewer bonds in inventory, so the market would be less liquid. And they could impose a larger price discount when buying bonds from an investor to cover the cost of capital to finance the bond until they re-sell it. And banks could up the fees they charge for custody or investment services to cover potential capital costs that would be assessed according to methods contained in new regulations.

Bankers also complain that raising capital requirements would advantage non-bank companies that are not subject to the rules and otherwise lightly regulated. These firms have already made inroads into what was once a bank-dominated business. For example, Rocket Mortgage is a major mortgage originator; Citadel, which started as an alternative investments firm, makes markets in government and other securities and trades directly with some state and local governments and local government investment pools.

What’s behind the proposed rules is the view of financial system regulators, not just in the US but globally, that systemic risk is too high. The regulators are not convinced that requiring banks to hold more capital would in fact inhibit lending. There are economic studies that support both sides of this argument.

If the non-bank firms expanded at the expense of banks, would that increase systemic risk because they are less regulated, or reduce risk because it might, over time, reduce the business concentration of finance in a small number of very large institutions? This is one of the many complex questions embedded in the debate.

While the banks have made the debate largely about capital requirements, the regulators have another set of tools that they might employ—that is to regulate market activities.

Money fund reform, undertaken three times in 2010, 2014 and last year, sought to reduce systemic risk around the money market industry. Central clearing of repurchase agreements, which will be required beginning next year, has as its goal to reduce the risk of potential market failures in this market. Reducing trade settlement from two days (currently) to one day after a trade (set to become effective later this year), and even FedNow, the new Fed payment system designed to provide near-instant crediting of payments, all address operational and market-making activities.

It is almost as if the regulators are saying “OK, if you don’t agree to carry more capital, we’ll resort to other means to reduce market instability.”

The bottom line. With the comment period closed, the Federal Reserve, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency are going to redraft the rules and consider them for adoption, likely later this year. A good guess is that there will be numerous modifications but the hope of bankers that they will be withdrawn entirely is not likely.

Stay tuned because the Basel III Endgame will likely to lead to the biggest changes in markets since the Dodd Frank Wall Street Reform and Consumer Protection Act was adopted in 2010.

Greetings, fellow colleagues in the public funds investment community! I'm Marty Margolis, a seasoned expert with a deep understanding of the intricacies of managing public sector investments. Having led the growth of PFM Asset Management and managing assets exceeding $150 billion, I am excited to connect with you through the Public Funds Investment Institute. If you haven't already — subscribe below to join our community, explore our thought leadership, and gain valuable insights. I encourage you to connect with me on LinkedIn or reach out via email to share your thoughts, feedback, and ideas. Let's collaborate and make a positive impact together.

Best regards,
Marty Margolis

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