Lessons Learned from Basel III Endgame Proposal: FDIC Director McKernan’s View
This week, Federal Deposit Insurance Corporation (“FDIC”) Director Jonathan McKernan gave remarks to the ISDA Conference on Trading Book Capital on Basel III Implementation.
As the title suggests, he focused on the interplay of the Fundamental Review of the Trading Book (“FRTB”) and the US Basel III Endgame proposal. He noted his view was that there were at least three lessons on weakness in the trading book framework:
1. Inadequate Measure of Risk
One lesson of the financial crisis was that the value-at-risk (VaR) measure, which had been designed to measure the risk of short-term fluctuations in market prices, did not appropriately capitalize low probability tail events, market liquidity risk, or credit risk and, more generally, was not calibrated to a period of significant stress.
2. Lack of Credible Regulatory Option
Another lesson was that regulators did not have a credible option for withdrawing approval of internal market risk models in part because the standardized approaches did not pose a credible backstop and, in part, because model approval was done at the banking organization-level instead of some subdivision, like the trading desk.
3. Capital Arbitrage Opportunities
Yet another lesson was that the boundary between the trading and banking books created opportunities for capital arbitrage by incentivizing banks to classify instruments as “held with trading intent” even where there was no regular trading so as to benefit from the reduced capital requirements on the trading book.
Director McKernan believes that the Basel III Endgame reforms offer the potential to better align capital requirements with the underlying market risks and reduce incentives to take on tail risk or arbitrage the trading book boundary. However, he suggests that the current proposal falls short in achieving these objectives.
In a previous dissent on the Basel III Endgame proposal, Director McKernan expressed concerns about design decisions made by the Basel Committee and followed in the U.S. proposal. He also suggested that the Endgame debate need not be binary.
He supports efforts to enhance the regulatory capital framework, but opposes reverse engineering higher capital requirements without considering the costs, benefits, or the underlying calibration framework. Instead, he proposes a phased approach to finalize the less contested aspects of the Endgame market risk reforms and then finalize the rest through future notice-and-comment rulemakings that can rationalize the U.S. implementations.
Given the bipartisan pushback on the proposal, Director McKernan’s suggestion of a phased approach may offer a path to at least some progress in finalizing parts of the Basel III Endgame proposal.
The Importance of Addressing Weaknesses
It is crucial to address the weaknesses identified in the trading book framework to ensure a stronger and more resilient banking system. By learning from the lessons of the financial crisis, regulators and policymakers can implement reforms that better align capital requirements with market risks and discourage risky behavior.
Director McKernan’s view highlights the need for a calibrated approach that takes into account both the benefits and costs of higher capital requirements. It is essential to strike a balance that effectively reduces risk while not overly burdening banks and hindering economic growth. Through notice-and-comment rulemakings, regulators can gather input from stakeholders and ensure that the final regulations are well-calibrated and considerate of the unique characteristics of the U.S. banking system.
The Benefits of Basel III Endgame Reforms
The Basel III Endgame reforms hold the potential to improve the regulatory capital framework and address the weaknesses identified in the trading book framework. These reforms can:
- Align capital requirements with underlying market risks
- Reduce incentives for banks to take on tail risk
- Minimize capital arbitrage opportunities
By achieving these objectives, the Basel III Endgame reforms can contribute to a more resilient and stable financial system. It is important to ensure that the reforms appropriately capture the risks inherent in the trading book and provide adequate safeguards against future financial crises.
Frequently Asked Questions
What are the lessons learned from the Basel III Endgame proposal?
The lessons learned from the Basel III Endgame proposal include:
- The value-at-risk (VaR) measure is inadequate in capturing various risks, such as low probability tail events, market liquidity risk, and credit risk.
- Regulators lack a credible option for withdrawing approval of internal market risk models.
- The boundary between the trading and banking books creates opportunities for capital arbitrage.
What is Director McKernan’s view on the Basel III Endgame proposal?
Director McKernan believes that the Basel III Endgame proposal falls short in aligning capital requirements with market risks and reducing incentives for risky behavior. He suggests taking a phased approach to finalize the less contested aspects of the reforms and address the remaining issues through future rulemakings.
How can the Basel III Endgame reforms benefit the banking system?
The Basel III Endgame reforms can benefit the banking system by:
- Ensuring capital requirements are aligned with market risks.
- Reducing incentives for banks to take on excessive tail risk.
- Minimizing capital arbitrage opportunities.
These reforms aim to create a more resilient and stable financial system.
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