Next Steps on a Much Improved Basel III Endgame

Publication of the revised Basel III endgame proposal earlier this month marks an important step towards completion of the global capital reforms, giving banks much-needed clarity on the likely calibration of the rules in the US. The new proposal is a major improvement on the original and includes a number of important changes that ISDA had advocated for. We're grateful to policymakers for engaging with the industry on its concerns and making these changes, which should improve the risk sensitivity of the framework and avoid disproportionate increases in capital requirements. There is still a long way to go, however. This is a highly complex set of rules, and we need to carefully analyze the calibration of each component and the implications for banks and financial markets.

In this new iteration of the framework, policymakers made important changes to improve the viability of internal models for market risk under the Fundamental Review of the Trading Book (FRTB). ISDA had previously highlighted that the testing framework was so complex and operationally challenging that it threatened to curtail the use of internal models. The removal of the output floor eliminates one disincentive for the use of internal models, while proposed adjustments to the profit-and-loss attribution test, the risk factor eligibility test and the capitalization of non-modellable risk factors respond to some of the industry's concerns. However, there are other issues that will need to be resolved to achieve a fully appropriate market risk capital framework.

Another important component of the new endgame proposal is cross-product netting. As ISDA has previously pointed out, the original proposal that US agencies published in 2023 didn't recognize the risk-reducing benefits of cross-product netting arrangements under the standardized approach for counterparty credit risk (SA-CCR). Without the option to use an internal model method that would recognize cross-product netting, this omission from SA-CCR would lead to disproportionate capital requirements that don't reflect offsets in a portfolio of products, including derivatives and repos. This would place additional strain on bank balance sheets and might affect their ability to provide liquidity, especially during periods of market stress.

US prudential regulators have recognized this issue and sought to address it. Under the new proposal, non-cleared derivatives and repo transactions - including trades between clearing members and their clients - would be recognized in the SA-CCR calculation. This is a positive change, but the methodology set out in the proposal is overly conservative and lacks risk sensitivity. This could result in capital requirements that do not accurately reflect the true economic risks associated with portfolios of repos and derivatives.

Recognition of the maturity mismatch between typically longer-dated derivatives and shorter-dated repos has been incorporated into the framework with a simple ratio, but the proposed methodology for the exposure calculation is ultimately calibrated against the gross calculation of derivatives and repo exposures. This is a blunt approach and we will work with our members to develop a recommendation for a more risk-sensitive methodology. Effective cross-product netting under SA-CCR is critically important to align capital with economic risk and allow banks to continue providing vital intermediation services at a time when client clearing is likely to increase with the implementation of the US Securities and Exchange Commission's forthcoming Treasury clearing mandate.

A further area where welcome progress has been made is the removal of a disproportionate capital charge for client clearing businesses at US global systemically important banks (G-SIBs). As ISDA had recommended, US regulators have proposed the exclusion of the client-facing leg of cleared trades from the credit valuation adjustment framework. When combined with the exclusion of clearing from the G-SIB surcharge, this removes a problematic flaw in the framework that would have increased capital by more than 80%, constraining client clearing and negatively affecting market stability.

The new Basel III endgame proposal is a key milestone in the completion of the capital framework in the US, but the end isn't in sight just yet. With an industry consultation now open until June 18, it's vital we use this time to properly scrutinize and test all components of the framework so we can provide an informed, constructive response to US regulators and forge a path towards a fully appropriate, risk-sensitive capital framework.