For those in banking, particularly at larger firms, the concept of "capital" can be nebulous. Until it isn't. When things are going well, and you're dealing in tens or hundreds of billions in shareholder capital, it can feel highly theoretical. When it's gone, it becomes obvious who funded a firm's operations (including salaries) while acting as a backstop for client deposits. Your role at any company is only as stable as your stewardship of shareholder capital is competent. This dynamic is especially true at a bank, where your constituencies often extend to the general public. The ultimate objective is to serve clients, use capital efficiently, generate shareholder returns, and build a balance sheet to survive a cyclical economy for generations, ideally while avoiding the instigation of a crisis along the way.
Historically, banks have had some difficulty doing all of these things, which has caused a few issues. Governments worldwide have had to step in many times to offer implicit or explicit guarantees that protect depositors while incentivizing an environment of risk-taking needed to make loans that fuel economies worldwide. In an increasingly global banking system, it eventually became clear that a more scalable approach was necessary to avoid a game of regulatory Whac-A-Mole, so bureaucrats did what they do best—they set up a committee.
Enter the Basel Committee. Formed by the G10 in 1974 and now consisting of 45 institutions across 28 jurisdictions, the committee has created three landmark proposals that have shaped banking today — Basel I, Basel II, and Basel III. Notably, the committee isn't able to implement these rules. Still, it enables global consistency for the rulemaking organizations (e.g., The Federal Reserve, OCC, and FDIC) to reduce or eliminate the risk of arbitrage.
When the committee developed Basel III in the wake of The Great Recession, increased capital was the blunt instrument used to reduce systemic risk, focusing on Tier 1 Capital (common equity and certain retained earnings). The math makes sense to a certain extent. After all, there would theoretically be less corporate waste while providing more of a backstop for customer deposits. At some point, however, shareholders will expect growth in return for their risk. If capital is unavailable for hiring talent, building new products, or funding acquisitions, shareholders will seek out this growth elsewhere (and so might employees).
Stagnating growth is a primary concern with the latest iteration of Basel III, which the committee has given the overly dramatic moniker of Endgame. The proposed rules released in July 2023 include several changes impacting more banks. If anything resembling this updated framework goes into effect, Endgame will lead to dramatic changes in what sort of returns shareholders can expect, how much clients can expect to pay for loans, or what kind of clients can expect to receive loans in the first place.
Why?
Interestingly, it largely stems from market and operational risk. While many of the changes involve standardizing processes used to measure risk across firms with $100B+ in assets (down from $700B), the changes in how market and operational risk are measured will restrict how the most prominent banks can use shareholder capital to invest in growth, making each dollar utilized for these activities more expensive.
"Because of the operational and market risk provisions of the proposal, much of what is driving the increase in the big banks' required capital are activities outside of simple deposits-and-loans banking, such as trading, market-making, wealth management, and investment banking," said David Wessel of The Brookings Institute. "Thus, banks with large such operations will be hit harder than those with business models more concentrated on lending."
J.P. Morgan Chase is one example of a hard-hit institution. The largest US bank by virtually any measure has substantial exposure across the most impacted businesses, and Jamie Dimon, in his annual note to shareholders, was very vocal about the impact on his firm:
If the Basel III endgame were implemented in its current form, it would hamper American banks: As proposed, it would increase our firm’s required capital by 25%, making our requirement 30% higher than it would be under the equivalent European Union proposal. — Jamie Dimon
The effect isn't limited to J.P. Morgan or the 36 other banks expected to be impacted by Endgame. There are some downstream impacts of higher capital requirements. If more shareholder capital is required to finance loans or market making, banks will need to charge more to maintain the same level of profitability. The impact on consumers may be direct (e.g., higher interest payments on a mortgage) or indirect (e.g., higher cost of goods due to higher business financing costs).
If you're one of the approximately 4,550 FDIC-insured banks in the US with less than $100B in total assets, you're in luck. You are exempt from the most restrictive capital requirements present in Endgame. Similarly, private credit firms that aren't subject to minimum capital requirements are preparing to play a more significant role in financing businesses and have successfully attracted investors with healthy yields.
Regional banks and private credit are essential in ensuring capital flows through certain parts of the economy. Their work keeps businesses afloat, serves consumers with residential mortgages, banking solutions, and credit cards, and innovates for segments of the population that need more from their partners.
There are limitations, however. Regional banks face difficulty because they can't necessarily attract low-cost deposits at the scale of a large firm (nor would they want to in many cases). Private credit investors would also be limited in their ability to offer competitive terms, often leading to them being the lender of last resort for many borrowers.
Rarely can they offer the full spectrum of services available at a $100B+ bank, and many clients prefer the convenience of having a single, stable banking partner. If the market drives more clients to these firms post-Endgame, it will be fascinating to see how they navigate through recessions (or worse) without the regulatory overhang of a large bank.
Regulatory and market pressures are aligning to drive new business models. Regulators are not rewarding size and scale in banking, while the lack of size and scale limits opportunities for regional banks. These pressures have driven the rise of fintechs that thread the needle by unbundling certain products from large institutions with the customization and service clients expect from smaller firms.
We see the opportunity as one to develop an open architecture platform that drives more financial products into the hands of our members through a network of banks and non-bank lenders, mirroring the benefits of large banks while building in solutions that banks aren't known for, including enterprise-grade analytics for families and founders. There are benefits, ultimately, to not being a bank that can lead to more flexible and cost-effective cash management and credit solutions while enabling more significant investments in improving the client experience.
Endgame for regulators appears to be an attempt at driving certain activities away from the nation's largest banks and to smaller institutions or outside of the banking system altogether. If the proposal is finalized in its current form, there will be a rush to build solutions that mitigate the impact on clients and the broader economy.
