The Federal Reserve has watered down its original plan to raise the capital reserve requirements of America’s largest banks by up to 19% as part of the final implementation of Basel III, a multinational agreement formulated to reduce the risk of bank failure in the wake of the 2008 financial crisis.

The backpedaling comes after the Fed received vociferous criticism from key industry players, who argued that the proposal would unnecessarily burden financial institutions, reduce profits and harm clients.  

Under the new proposal, capital requirements would be halved, amounting to an increase of 9% in the aggregate. The heightened capital requirements would also no longer apply to banks with under $250b in assets.

Capital reserves

A bank’s capital represents its liquid assets it does not have to pay back. Drawing on high-quality capital reserves allow a bank to continue to perform its vital functions, such as lending, during stressful economic conditions.

Total amounts of capital are decided by the banks, but minimum requirements are set by the Fed. Currently, the required minimum Common Equity Tier 1 (CET1) capital ratio for large banks is 4.5% relative to a bank’s risk-weighted assets.

CET1 represents the highest quality forms of capital that can be easily liquidated.

These requirements also include additional buffers tailored to specific banks according to particularized assessments of risk, including a minimum CET1 2.5% stress buffer and (if applicable) a minimum CET1 1% surcharge.

The Basel III endgame would change the way that banks calculate their risk-weighted assets through a series of complex requirements that would affect how those ratios are calculated. According to the Fed’s original plan, this could have effectively raised minimum capital requirements by 16%, although some commentators say it could have been as high as 20%.  

Cost/benefits analysis

Many high-profile bank collapses have been tied to inadequate reserve capital, including the failure of Silicon Valley Bank (SVB) last year. In that case, SVB overinvested in government bonds. When interest rates on the bonds increased unexpectedly, it led to a catastrophic bank run and liquidity crisis.

The collapse of SVB in particular contributed to the Fed’s original reasoning to increase capital requirements, and apply the requirements to smaller banks holding between $100 billion and $250 billion in assets.

The higher the bank’s capital reserves, the less likely it is to fail under strenuous conditions. However, the more capital a bank is required to hold as a percent of its total assets, the less profit it can make.

This is because capital is more expensive to maintain than debt as a source of funding. Higher capital requirements can also limit key shareholder value maximization efforts, such as stock buybacks.

Industry participants and regulators say that these costs can ultimately be passed on to customers.

This led to criticism among Fed officials that the plan to dramatically raise capital requirements might cause more harm than good.