New UMD Smith SERC-ABA Report Defines ‘Basel III Endgame’ Flaws

Federal regulators are preparing new rules to strengthen the financial system by requiring banks to increase the capital on their balance sheets. Banks have countered that they are sufficiently capitalized, and further requirements could compromise consumer lending and drag on the national economy.

Supporting and illustrating the latter are new findings from the American Bankers Association (ABA) and the Smith Enterprise Risk Consortium (SERC) at the University of Maryland’s Robert H. Smith School of Business.

The 2023-proposed “Basel III Endgame (B3E)” will apply to banks with $100 billion or more in total assets – “imposing an entirely new approach to computing capital charges and risk-weighted assets associated with operational risk,” says Smith Professor of the Practice and SERC Director Clifford Rossi.

These new capital standards on operational risk are estimated to increase risk-weighted assets for large banks by $1.4 trillion and $550 billion for smaller banks.

“This approach is inherently flawed methodologically. Its deficiencies are further compounded by the fact that the existing stress capital buffer, which is a major component of minimum required capital calculations, already includes a component for operational risk under a severely adverse scenario in the annual bank stress test exercise,” write Rossi and his ABA co-author Warren Hrung (former economist at the Federal Reserve Bank of New York), in a subsection of their findings. This “blending” of regulatory capital and stress tests likely leads to an excessive amount of required capital for operational risk.” 

The banks would “subsequently face higher capital costs, with the result of eroded profitability, higher raising costs or constrained credit to bank customers—or a combination of all three—with a negative impact on economic growth,” they write in a ‘Methodological Flaws’ subpiece.  “These changes relate operational risk capital to bank income, expense and revenue from various banking activities. Moreover, the ORC charge grossly overestimates the amount of tail operational losses given actual historical loss experience. 

Rossi and Hrung propose “an alternative” to the regulators’ move “that rests upon a stronger theoretical foundation and is operationally tractable and analytically consistent.”

B3E Origins

The regulatory community was caught off-guard by the U.S. regional banking crisis – beginning with the high-profile fall of Silicon Valley Bank and First Republic early in 2023, prompting investor panic around other banks with perceived vulnerabilities and sparking a ripple effect of sell-offs and bank seizures.

U.S. regulators last July unveiled the ‘endgame’ proposal from a framework established by the Switzerland-based Basel Committee on Banking Supervision – a panel convened by the Bank for International Settlements to ensure regulators globally apply similar minimum standards on banks to survive loan losses during crises.

However, Rossi says the move has been “a bit rushed and far from ideal.”

“The old standby regulatory response to a banking crisis to raise capital is ineffective and, in the specific case of B3E, misses the mark entirely,” he says. “It will demotivate banks to invest in operational capabilities, pushing more banking activity to less regulated non-bank entities. It further will impose higher costs on consumers without an empirical basis.”

Read the SERC-ABA full report “Rethinking Operational Risk in the Basel III Endgame.”