Regulatory Ripples: Basel III in 2024

January 29, 2024

Cheryl Brown

In this episode of The Purposeful Banker, Q2's Steve Collum, senior manager, Strategic Advisory Services, digs in with Jim Young about Basel III and the ripple effects the changing regulatory landscape may have on the banking industry.

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Jim Young

Hi, and welcome to The Purposeful Banker, the leading commercial podcast brought to you by Q2 PrecisionLender. I'm your host, Jim Young, as we tackle the topics on the minds of today's best bankers. Today we're going to talk about the new capital requirements proposed by U.S. bank regulators, which banks have recently submitted their comments on. We'll likely use the title Basel III for short, though this set of regulations varies from the original ones proposed. I’ve got to admit, I did about five rewrites of this intro just figuring out how to bring this topic up, which should give you an idea of its complexity. Fortunately, we've got just the right man to help us navigate through the murky waters of Basel III. I'm joined by Steve Collum, who heads up our team of strategic business advisors for Q2 PrecisionLender. Steve, welcome to The Purposeful Banker.

Steve Collum

Jim, thank you. Thank you for having us or having me. And I know capital conversations are not really at the top of all of our bankers’ minds, but it's at the forefront of the CEOs of some of our largest banks right now, so I appreciate the time to try to demystify these regulations and talk to you about really what's going on in the market today.

Jim Young

Alright, well first step with demystification really is sort of a broad question. I'm sure a portion of audiences already knows the answer to it, but let's just get it out there as well. Just for posterity, what is the deal with Basel III and who does it impact?

Steve Collum

Yeah, so I'm going to take us back in time to sort of answer that question to make sure everybody understands what Basel is, right? We've viewed Basel III terminology a couple times already in this podcast, but Basel really is a committee that puts out standard guidelines on how to calculate calculations at financial institutions. The one we're here talking about is capital. That capital regulation, right, was first proposed in 1998. We're now in Basel III, as you've called it, which was proposed in 2017 and due to some global circumstances, right, it just has not been implemented across its committee members. Right. The committee has about 38 members and the US happens to be one of them. So in the second half of 2023, the US regulators proposed what Basel's ratio look like for our financial institutions. That proposal really limited to banks over $100 billion in assets or if they have trade in assets over $5 billion.

So it is really a bifurcation of who it's going to impact and what these methodologies and calculations will look like. With that said, it's going to impact everybody, Jim, and that's because it's a competitive market. You have banks under $100 billion competing with banks that are $100 billion. You also have U.S. banks competing with European banks. And so these regulations, while the calculation might have to be implemented by $100 billion or $5 billion trading assets, it really impacts everybody in the financial market.

Jim Young

Alright, well, I'll avoid the jokes about a regulation starting in 2017, and here we are at the end of 2023 talking about it, hasn't been implemented, but I'll just say that feels about right. But let's dig in a little bit more onto the impact, and I guess really what does this change, first off, for those banks that are impacted? And you mentioned it kind of affects everyone. So the other thing I would ask is how does it go kind of downstream from the ones that are directly sort of targeted maybe not the right word, but I guess we'll go back with impacted again by the regulations.

Steve Collum

So I'm going to answer this question like any good economist, it all depends where you sit. It's my favorite line, but it's true. So I'm going to try to do a visualization for our listeners out there. Imagine a line graph where you have three different lines. You have our largest banks, these are the G-SIBs out there. You have our large regional banks. They're calculating capital as a ratio of assets. Let's just use that metric. You're going on this line for a real long time and 2023 hits with the proposed regulations with an implementation date. For our G-SIBs, it's a pretty big deal. They're basically going to hit a wall and have to stair step up to new regulations while our regional banks are going to have to increase capital as well. But because of where they were prior, it's not that large of an increase.

It still is an increase. It's new concepts, but the biggest impact is going to be felt by our largest institutions. And the reason for that is they're going to have to calculate credit capital differently for the largest institutions than they're used to. And for our regionals, a new concept is coming into play. That's the operational and market risk capital. We won't really dive into that today. We'll really focus on the credit capital, but that's how it's impacting them. For the folks who don't have to look at this new calculation, right, they're going to compete in the market where these banks are going to have to hold capital at these levels. So they need to understand them because when you go to price a loan, when you go to look at a relationship, or even when you're in that trusted advisor status, right, that customers could be looking at what services are offered by a bank that's impacted by these regulations as well. So it's unfortunately, it may not bleed into your calculations, but you still do need to sort of pay attention to it.

Jim Young

And I guess, and this is again, this is marketing guy stepping into not just a banking conversation, but a banking regulation conversation, which is a whole lot of landmines there, but I would think it's going to impact anybody that's competing in a deal, right, for that. If I'm the smaller bank, I've got to sort of understand, let's say I'm competing with the bigger bank that's impacted by this, I've got to understand how that's going to impact how they're pricing, right?

Steve Collum

Yeah. Because they're going to be pricing in a very different methodology than, or they potentially could be pricing in a different methodology than what you're used to seeing. Right. So that's just if you're competing for a simple bilateral sold type of deal, Jim. Say you get into a larger syndication market and you want to be a participant with some of these larger banks. Right. Now we're getting into a whole ‘nother rolled out, well, why are you pricing it this way? Our internal tools would tell us X, Y, and Z, but they're going to have to work through these murky waters to be able to participate.

Jim Young

So yeah. The TLDR for people is this is impacting everyone. We basically, that determines it.

Steve Collum

Yeah.

Jim Young

So fair to say that the U.S. banks that are directly impacted by this have been less than thrilled with the proposed regulations. Can you sort of outline their concerns?

Steve Collum

Yeah, Jim, I think that's the nice way to put it.

Jim Young

It's a family podcast we run here, Steve.

Steve Collum

Yeah. Yeah, if you were to read a lot of the headlines, there is lots of concerns from our largest institutions. The main reason they're concerned is their capital requirements are going to increase. There is estimates within a pretty actually tight band for statistics in my opinion, but the most recent one I've seen is 20 to 25% increase in capital. Now the issue with it is these largest banks don't think they should be required to increase their capital based on where they currently are. Right. They don't think the regulation should actually require additional capital hold. They believe they're well capitalized today, and the additional capital is just a buffer that is not needed. That's the first. Right. When you read any of those articles, that's usually what it's aimed at. The second one is we started the conversation talking about Basel III and the timeline. So Basel III finalized was proposed in 2017, and then each of these committee members or members of the committee will propose their own regulations.

So there's Canadian regulations out there, there's European, there's U.K. regulations. Now we have the U.S. regulations. So the second-biggest issue is for these banks is the U.S. regulations deviate substantially from the Basel III finalize proposed regulations and they deviate in a form that is taking away tools for these financial institutions and how they calculate capital and they're trying to standardize it. If you go back to that line graph I was trying to help everybody visualize, right, the reason that there's such a stair step for our globals is because they have these internal tools that could actually calculate or estimate, let's not use the word calculate. Let's use the word estimate, what they thought the capital should be held based on a commercial or customer's risk profile.

So that's the second thing that is really driving it. And then obviously when you take away a tool, there's uncertainty on what you use in the future. And so that's the third aspect that I think we should dive into to a degree because our bankers are going to be seeing different returns out there potentially. There's going to be a bunch of noise that they're going to have to wade through in order to continue to still be a trusted advisor to their clients.

Jim Young

Yeah. I should mention here that we've actually put out a blog post and a paper as well, and I think we'll provide some links to them in the show notes on the site that kind of dive into the numbers and calculations on this. And for me, again, as the non-banker, I could even look at it and go, wow, that's changing risk-based pricing in a way that I've, a really radical, well, maybe radical in a very big way. How about that? We'll say that.

Steve Collum

Yeah.

Jim Young

But along those lines, then let's just say I'm a commercial banker, one of these FIs, it's going to be if the regulations, again, we're still on that point, nothing's been implemented, but based off of what was proposed, let's say they're proposed and they're implemented. I'm a commercial banker at one of those FIs. Can you kind of take me through a hypothetical deal and sort of do the comparison between how we would price it right now and what I'll call, and again, I'm going to keep calling it Basel III. It's a better easy, quick name. The Basel III pricing approach slash U.S. version.

Steve Collum

So I'm happy to do that, Jim, and you asked a math guy a math question. I really want to take you through the entire formula, but I won't do that to you. But for these complex banks, what you have to, the complex largest banks, to answer your question, it's another dependence, but it depends on where you sit. Right. And so you could have a banker very focused on a traditional C&I deal or another banker focused on commercial real estate. The regulations are not a short read, we'll put it at that. It's very long. And so they address different types of credit lending with different standards. So I'm going to try to give two simple examples. One is a traditional C&I facility. This is an externally rated deal. It's got a triple B. And based on market pricing that we got from one of our good friends here at PrecisionLender, we would've estimated a return that is 10% higher in today's regulation versus the proposed regulation.

So what that really translates to is 10% higher capital hold on an investment grade or triple B facility for a C&I space. If you switch that over to CRE space and we look at a deal that has a loan to value ratio or of 75%. Right. So the borrowers come in with 25% down, which is a decent chunk of change for lending. We're actually going to see returns decrease north of 25%. So it really just depends on where you're sitting and what type of lending you're doing. And that really is going to create a resetting on how bankers look at their deals and look at their relationships. And the biggest thing here is we don't want to get into the mode with these new regulations on focusing on the calculations, right? We're talking about them, I love math, but when you get into the street and you're actually working with a customer, we want to provide tools to our bankers so they can easily translate what it used to be versus what it is now.

So they know how to react to the market, right, versus it's the terminology that we love using at PrecisionLender, it's the price setting versus the price getting. And the way that they're going to have to start thinking about this is they're going to have to be able to do a crosswalk, but you want to minimize how they're actually doing that crosswalk and provide them the right tools so they're not sitting there trying to read these very large regs to understand what's going on. So it's going to be impactful, but with the right tools, it could be navigated easier, so …

Jim Young

Alright, and forgive me if the question I'm about to ask has already been partially answered here because one of the parts I was sort of trying to understand in going through this is that what we're talking about here is what the banks have to report, right? It's not necessarily how they would price it in reality. And if that's sort of what you were getting at before, can you kind of maybe patiently repeat it or explain it again to me?

Steve Collum

So absolutely Jim, and this is where we're going to get into some philosophy on pricing, right, because everything in pricing is an assumption. And everything that you actually price is a forecast. Everything that you forecast is wrong after you're done with it. Right. So those are just the truths that I hold to myself.

Jim Young

Right.

Steve Collum

With that said, the philosophy is going to vary differently across FIs, right? To your point, when these financial institutions actually have to report to the regulators, they're going to have to report under the new regulations. Going back to the examples that we just walked through, right, providing the right tools to be able to crosswalk between the two different returns, you necessarily don't have to do that. You could continue to look at, used the term earlier risk-based pricing via the credit capital calculation side. You could continue down that road and do that translation and that crosswalk externally at the management level. Right.

So the bankers don't see an impact to it. They use our current tool, but then the translation happens outside of it. So it's really an option. And from my experience and what we've seen, you're going to have people who take to both sides of the philosophy of, heck, we're not going to change anything for our bankers. We're going to keep this credit risk base pricing or we're going to adopt it to the regulation so they know what's going on down market, not down market, down within the organization for the bankers, but they know how that's impacted the portfolio in the end. In the end, it's about making sure your pricing aligns to your financial institution strategy. So you have two options to do that. Hopefully I answered your question. I know I gave you both options. OK.

Jim Young

Yeah, no, I think that makes sense. So any insights into how advisors are preparing again for what's proposed, but I imagine you got to start preparing either way. I can't assume that it's going to just, yeah that it's going to get completely reworked or that sort of thing. So how are FIs trying to prepare for this?

Steve Collum

That's a great question, right? I've been talking about, I'm almost talking like I'm in one of the financial institutions. They're preparing now for the proposed regulations. Some of them have taken the philosophy of they will treat this as a reporting and a portfolio exercise, so they will not push down these new regulations to their bankers. Others are saying, we're going to adopt the regulations exactly as it is, and we want our bankers to be able to, because they want the bankers to understand the returns and how it's flowing through to the portfolio. Interestingly, we've also heard some creative solutions across the majority of our FIs that we've talked about where they are taking the opportunity to look at how they calculate capital and potentially come up with their own internal methodologies. Those internal methodologies would then very be bespoke. Right. Basel is a standard that people adopt some version of because the proposal is so far away from that standard and they're wondering, well, what's the best way to actually do this? Right. We don't have to sort of align to the old standards. Right.

So now can we come up with our own internal methodology that makes sense for how we're serving our customers? And so there's really three options that we’re dealing with, Jim. One is it doesn't get pushed down, one is it does get pushed down. And the third is let's get creative around it, which go back to the beginning comment, is going to create even murkier waters when all these financial institutions try to compete with each other.

Jim Young

Yeah, exactly. Finally, and I say finally, but I reserve the right to ask you one more question as well, but we got the Q2 PrecisionLender pricing database kind of thing that Anna-Fay Lohn and I go through each month with the pricing update, where we're sort of looking at what's going on in the market right now. I'm curious if that data offers any sort of additional guidance into what a Basel III world might look like.

Steve Collum

So our data is very extensive, as you know, Jim. We've gone through it and because the regulations are so detailed, we're taking a best guess at this point. So I'm going to cite a number, but it's the best guess on a lot of assumptions we've made. But we have a lot of great data. And so I mentioned earlier that we have folks citing about 20 to 25% increase in capital calculations. When we actually look at the credit side of this, we're seeing around 13% on average of an increase in credit capital. Now, the difference between the 20 and 25% and our 13% is we're assuming that 20 to 25 that we're seeing in the press also includes operational market risk capital. We have not analyzed that yet, but we do have looked at the credit capital side. So we're once again mentioned earlier, statistically we're within that same band.

So that's the high-level statistic. What's actually interesting is it matters what your portfolio looks like because you're going from internal models that are calculating what we call risk weights to a standardized risk weights. If your internal models are far away from those new standardized risk rates, you could be seeing something much higher than a 13% increase. But if they're calibrated that are relatively close, you could be seeing a lot less. And so while I give you that percentage, I also want to caution folks that you really need to look at your portfolio and do a deep dive analysis on that because you could come to a different conclusion yourself.

Jim Young

Alright. And like I said, I reserved the right to ask one more question. And I was just sort of struck when you were kind of going through the hypothetical ones and you mentioned just as an example, how much more capital up there you'd have to keep for a CRE deal. And I'm wondering if you can see, and again, if you were like, Hey, I do not want to be in the business of forecasting on this sort of thing, but I just wonder if you could see bigger banks maybe in particular areas saying, we're just not going to do these type of deals anymore and therefore regional, I mean, I don't want to say opening up a market, but becomes someone's got to fill the need for these type of deals. Could you see that sort of shifting down market, some of these particular loan areas?

Steve Collum

So Jim, you picked an interesting point to come back to. CRE and the proposed regulations, we've looked at pretty in depth here at PrecisionLender. And the interesting aspect, and I only picked one loan-to-value ratio, right?

Jim Young

Right.

Steve Collum

The site here.

Jim Young

Fair.

Steve Collum

But the market realities that we're seeing don't align to the regulations. So what that means is the higher loan-to-value ratio is usually associated with investment-grade companies. Right. You require less cash down or capital or collateral, whatever collateral you bring to the table for those investment-grade companies. So therefore you usually get a better price. While the higher or the lower LTVs, so say you have 50%, those are usually your less secure borrowings because you require so much collateral. So it's all backed on the collateral, but potentially the underlying customer doesn't have the cash flow for it. So then that gets higher pricing in the market.

And I've spent time with the market insights team looking at this. And so what's going to happen with these regulations is because the loan-to-value is higher on the investment grades, right, it needs higher capital. And I think where you're going is, well, will banks actually service this category? And that is a big fear right now from our largest banks, that some private funding source will come in that is not subject to these regulations. So therefore they don't have to look at these capital calculations and offer price advantage to be able to pull that out of the market. And essentially what's happening is what the regulators are trying to regulate from an overall pie perspective is going to get to a smaller pie because that money's leaving the system. So if I'm just looking at the math, I can see the fear that these larger banks have as well because it doesn't align to the market realities that we're seeing today.

Jim Young

Alright. Well Steve, thank you so much for taking the time to come on and talk to us about Basel III. I have a feeling you will probably be back on this podcast in the future because this story is continuing to unfold and I don't think it's really close to its conclusion. I should mention that in the State of Commercial Banking, they're going to be sort of addressing some of these topics as well when that comes up. I want to say early February I think is when the webinar is going to be and we'll have again, links for that and encourage everyone to sign up for it. Mentioned again that you've done some really good work in the blog and a white paper on this that we'll have links to on the podcast if people want to dive into the math and the numbers. But for now, Steve, thanks so much for coming on.

Steve Collum

Yeah, Jim, thank you for having me.

Jim Young

And that's it for this week's Purposeful Banker. If you want to catch more episodes of the show, please subscribe wherever you listen to podcasts, including Apple, Spotify, Stitcher, iHeartRadio, and more. You can also find a video version of today's episode on our YouTube channel. If you have a minute to spare, let us know what you think in the comments. You can also head over to q2.com to learn more about the company behind the content. Until next time, this is Jim Young. You've been listening to The Purposeful Banker.