Basel 3 Endgame: Regional U.S. Banks Must Prepare for Compliance

This interview was led by DerivSource editorial staff.

The US Federal Reserve published its proposed Basel 3 endgame standards in July 2023, covering how to compute capital charges on market, credit, operational risk, and liquidity risk. It also announced that the proposal was going to be open for comments for several months—this period had eventually been extended until mid-January 2024. The new rules, also known as the Notice of Proposed Rulemaking (NPR) for Amendments to the Regulatory Capital Rule, reduce the threshold from $700 billion AUM to just $100 billion, impacting a slew of smaller and regional banks that were previously not in scope for Basel 3 capital reporting. In a DerivSource Q&A, Valerie Fontaine-Aubry, head of market risk practice for the Americas at Murex, discusses regional bank readiness for the new rules and how an integrated platform can help these banks efficiently manage the new requirements.

Q: What are the main requirements and why do these requirements pose a challenge to regional banks?

A: The new proposed rules involve a substantial revision of bank regulatory capital requirements. Under the previous Basel framework, banks were allowed the flexibility of internal approaches for their risk-based capital standards. However, the endgame revisions demand a shift to standardized models for most risks, with only market risk allowing a bank’s own methodology. This is a big shift and a challenge for regional banks, which are new to this revamped regulatory landscape.

Regional banks are being impacted by changing thresholds. Before the Basel 3 Endgame, banks needed to have high levels of assets under management before having to report to the framework. However, with the proposed Basel 3 Endgame, a bank with a total asset size of more than $100 billion or with a significant trading activity will become eligible for the new risk-based capital standards. To take an example, this dual approach ensures that banks whose trading activity represents more than10 percent of their total assets but are below the $100 billion mark fall under the stricter capital requirements.

Many smaller institutions that previously did not have to report capital charges now find themselves in scope. As of today, most regional banks have conducted some analysis on the new Basel capital framework, and how it could impact them. But it is not the same as developing readiness for regulatory compliance. The comments period was short, and commenting was difficult for these firms that now face the daunting task of overcoming the same challenges as larger institutions. However, unlike their bigger peers, regional banks are handicapped by limited resources, a lack of deep expertise in house, and inadequate technological tools.

Another challenge for regional banks is the mid-year deadline. The new reporting rules come into force in July 2025, so firms will need to maintain two different regulatory capital charges reporting regimes for the first half and second half of the year. This adds another layer of complexity on top of their existing internal risk management practices. Here, regional banks are at a significant disadvantage compared to their well-resourced Tier 1 and Tier 2 counterparts.

The smaller the institution, the steeper the road to compliance with the new framework will be. Even though banks technically have a three-year transition period starting July 1, 2025, to comply, they will still need to demonstrate proactive due diligence much earlier.

For regional banks that haven’t been planning for years, the Basel 3 endgame may force them to rapidly revamp their internal workflows and governance to adapt to the new demands of the framework, requiring a weekly computation of capital charges under the current proposal.

Beyond the calculations themselves, regional banks must also address the challenges of data sourcing and data management. They need robust systems and processes to ensure they can consistently provide the right level of clean data at this increased frequency. With the new Basel framework, inconsistent or inaccurate data can quickly lead them to very punitive risk weights, directly impacting their capital levels.

Q: Endgame requires banks to model trading risks at the level of the individual trading desk rather than at an aggregate level. Why is this a challenge for regional banks?

A: This question touches on a very sensitive aspect of the Basel 3 regulatory framework. Before, capital charges were calculated at the top level of banks, across business lines. Banks could therefore optimize their capital across desks. With the Basel 3 endgame, capital charges are now computed at desk level. This new reporting by desk prevents institutions from recognizing the risk-mitigating effects of hedging. This is especially true for regional banks, which don’t have the big trading desks of larger institutions to offset some of their exposures through other positions within the same desk. In addition, this regulation also restricts diversification benefits across risk factors thanks to the introduction of standardized risk buckets and risk weights for each risk factor type.

Overall, the combination of this standardized bucket approach and desk-level calculations can potentially increase capital requirements, particularly for regional banks with less diversified portfolios. It overestimates their regulatory capital compared to their true economic situation.

This means that traders are becoming active players of capital charges optimization. They now need sophisticated tools to quantify the capital charge impact of their activities at desk level. This adds another layer of complexity on top of their existing risk management considerations. This framework forces them to add more parameters to their strategies, considering not just potential profit and loss, but also the capital implications of their decisions.

Q: With regard to credit risk, endgame introduces a new requirement to move to standardized approaches for risk-weighted assets (RWA). Why is this a challenge for regional banks?

A: The U.S. regulator is now requiring a more uniform and objective approach to regulatory risk reporting by banks. For example, operational risk management used to be somehow subjective; now, it needs to comply to a standardized framework.

The same spirit applies to credit risk management, where we see a major push for standardization with the Basel Endgame.

This new framework simplifies, but also potentially tightens, credit risk reporting for banks. Previously, a tiered system existed, with larger banks (Categories I and II) utilizing the more complex Internal Ratings-Based Approach (IRB), while smaller banks (Categories III and IV) could rely on a simpler Standardized Approach (SA).

Under the new regime, all banks (Categories I through IV) must adhere to a revised Standardized Approach. This represents a significant change for all institutions. Larger banks will face a more conservative approach than their IRB models, potentially leading to higher capital requirements, and smaller banks need to adopt a more complex method compared to their past practices.

Q: Why will this be a challenge for their risk management teams?

A: These smaller banks, Categories III and IV, are mainly impacted by the move from CEM (Current Exposure Method) to SA-CCR (Standardized Approach for Counterparty Credit Risk). While still “standardized” in spirit, SA-CCR is a much more complex calculation due to the risk sensitivity in its add-on parameters.

With CEM, the data needed to compute the EAD (potential Exposure at Default) was relatively small and easy to manage. For SA-CCR, the data challenge is considerably larger. Trades must be classified depending on their primary risk factors and further into hedging sets and subsets. Also, the add-on calculation requires in-depth knowledge of the payoff of the product to map correctly to the regulatory buckets (particularly for nonlinear products).

Using a specialized solution becomes key here for banks to extract and rationalize the relevant data usually available in their front office platform. The aggregation piece required to compute SA-CCR is the easy part.

Here again, regional banks come at a disadvantage compared to better equipped larger institutions with more resources and expertise. The tight deadlines and complex changes pose a significant challenge for them, requiring them to learn and adapt quickly to these new approaches brought by the new normal.

“An integrated platform enabling traders to see the whole trade life cycle—from pricing, trade booking, sensitivity and P&L computation down to FRTB SA capital charges impact—offers firms an advantage when assessing the cost and value of a trade.”

Q: Murex has worked with top tier banks on compliance with new Basel rules. What lessons learned from working with Tier 1 banks can help smaller regional banks working toward compliance?

A: An integrated platform enabling traders to see the whole trade life cycle—from pricing, trade booking, sensitivity and P&L computation down to FRTB SA capital charges impact—offers firms an advantage when assessing the cost and value of a trade. It enables traders to think about all the constraints in one go. Much like traders see the credit valuation adjustment (CVA) charge immediately when pricing a trade, the FRTB cost impact at desk level should also be visible when pricing a new transaction. Especially for large transactions, it is essential firms understand the capital costs of their strategy. Firms need intraday visibility on risk and capital costs, which even for Tier 1 firms is not easy.

Murex is an ISDA-licensed vendor and developed its FRTB packaged solution over the course of implementation in 16 jurisdictions across the globe and incorporating lessons learned in the process. Murex can guide US firms from an advisory and technology perspective and working with Murex provides reassurance to the regulator that a firm is on track to implement FRTB in 2025. However, institutions will also need robust internal governance to manage the transition well.

The strategy Murex has taken at the beginning with its international Tier 1 clients has been to implement Basel 3 compliance following the Basel model interpreted using the European jurisdiction assumptions. At the time, Europe was the most mature jurisdiction, so it allowed our clients to implement a solid baseline that would be adapted to their local regional regulations once it became available. This is the blueprint Murex recommends to regional U.S. firms impacted by Basel 3 endgame. The main challenges are around sourcing and validating the data to support the computation on a schedule that is much more frequent than they are used to. Murex offers the tools and uses an iterative approach to support clients big and small to source and build the data feed they need.

When it comes to technology support, regional banks likely do not have dedicated technology teams in house to support and develop regulatory reporting systems once they have gone live. Adding new products, with the necessary data sourcing, and updating the systems to accommodate new rules can be difficult. Many smaller firms are turning to vendors like Murex to see how they can facilitate and reduce the time to market when they want to trade a new activity. Because of Murex’s deep expertise and broad catalogue of instruments, there is a likelihood the solution already offers the new features they are seeking to add. Murex helps them adjust and adapt their processes, data and risk computation and get to market faster with newly traded products.

“Compliance with the new requirements means that firms will need a better tool to assess the impact of their trade activity and validate and report data more frequently.”

Q: Other than compliance, are there other benefits a regional bank may experience by implementing new technology to comply with the Basel 3 endgame requirements?

A: Compliance with the new requirements means that firms will need a better tool to assess the impact of their trade activity and validate and report data more frequently. When firms put in place a risk management tool that is more aligned with the front office, they will be able to better manage their risk appetite along with the new regulatory capital impact. A positive consequence—albeit at a high cost—is that hedging will probably become more streamlined and there will be better collaboration within teams inside the banks.

Q: What actions should a regional bank be taking now to comply in a timely manner?

A: What we would recommend to regional banks is to follow what most of our clients have done in the first steps of their implementation.

They started by focusing on their desk-level capital allocation. To optimize regulatory capital within the new framework, banks should indeed analyze their current desk structure and associated risk profiles to ensure capital is distributed efficiently across desks.

Today, most firms should have some sort of tool to at least estimate their regulatory capital through a quantitative impact study, a QIS.

The road to the Basel 3 Endgame compliance is not a one-shot computation, it’s an iterative process that may lead them to bring some changes to their current desk organization and how portfolios are managed across desks.

With the new framework brought by the Basel Endgame, market risk regulatory capital gets more attention, and effective risk management requires a closer collaboration between front office and risk functions.

As mentioned previously, intraday risk management is crucial, and traders need access to sophisticated tools and technology. This isn’t just a pressing need for regional banks, but a growing trend across institutions of all sizes. By equipping traders with these capabilities, banks can achieve a seamless convergence of front office and risk functions, enabling informed trading decisions alongside robust risk mitigation and capital impact awareness.

To learn more about MX.3 Enterprise Risk and Regulatory Suite, download the brochure.