The capital floor imposed on internal models by US regulators could prevent five of the country’s largest banks from realising hoped-for capital savings from the switch to the new standardised measurement approach (SMA) for operational risk.
US dealers were anticipating large reductions in operational risk-weighted assets (RWAs) under the SMA – part of the revised Basel III regulatory framework, which was finalised in December. However, if the SMA were implemented today, an analysis by Risk.net suggests the so-called Collins floor would prevent five of the largest US banks – JP Morgan, Citi, Morgan Stanley, Wells Fargo and State Street – from turning these operational RWA reductions into capital savings.
The amendment, proposed by Republican senator Susan Collins of Maine and implemented by prudential regulators in 2013, requires banks to evaluate their capital adequacy against the Basel standardised methodologies for credit and market risk. Put simply, if standardised credit and market RWAs exceed the total RWAs calculated under the advanced approaches, banks are bound by the former.
“I had thought the SMA would give them some relief, but if they’re already at the floor, they will not get any relief,” says the head of operational risk at a large New York-based bank. “SMA was pushed by these banks, especially JP Morgan, to reduce required capital as opposed to the advanced measurement approach [AMA].”
Jamie Dimon, JP Morgan chief executive, wrote in his 2016 shareholder's letter that operational risk capital “should be significantly modified, if not eliminated”.
A quantitative impact study conducted by the Basel Committee suggests operational RWAs will decline by 30% in aggregate for global systemically important banks (G-Sibs). US banks were expected to see the greatest reductions as they are currently required to hold greater amounts of op risk capital under the AMA than their European peers.
As of the fourth quarter of 2017, five US banks were constrained by the Collins floor (see chart), meaning total RWAs calculated using standardised approaches exceeded total RWAs calculated using the advanced approaches. Wells Fargo did not issue exact figures for its RWA totals as of December 2017, but stated in its earnings release that its capital ratio was calculated under the standardised method.
As a result, even if one of the banks were to realise a reduction in operational RWAs under the SMA, this would not be reflected in their minimum capital requirements. None of the banks had responded to a request for comment by press time.
Among the US G-Sibs currently capitalised according to the advanced approaches, Bank of America Merrill Lynch is closest to being constrained by the floor, with total RWAs calculated under the advanced approaches barely 1% – or $17 billion – above those calculated under the standardised approaches.
Goldman Sachs has $62 billion of headroom, with total advanced RWAs 11% greater than standardised, while BNY Mellon’s advanced RWAs were $19 billion, or 12%, higher than its standardised measure. Those banks above the floor could still derive some benefit from the switch to the SMA.
The actual impact of the Basel reforms on banks will not be felt for some time, since the SMA only begins to take effect from 2022 and won’t be fully implemented until 2027.
SMA was pushed by these banks, especially JP Morgan, to reduce required capital as opposed to the advanced measurement approachHead of operational risk at a large New York-based bank
The final impact of the switch will also be skewed if regulators impose discretionary Pillar 2 add-ons to make up for perceived shortfalls in capital requirements produced by the SMA. The Basel quantitative impact study does not take into account current Pillar 2 capital add-ons from national regulators – meaning projected capital decreases could be understated and increases overstated.
Furthermore, while not all large US banks may see a reduction in minimum capital from the switch to SMA, they could see a reduction in stressed capital requirements. The Fed has not historically factored the Collins floor into the quantitative portion of its annual stress test, the Comprehensive Capital Analysis and Review.
“Standardised risk weights are used in the stress test, and the stress test is the constraining ratio for the largest banks,” says Brian Kleinhanzl, an equity analyst at Keefe, Bruyette & Woods. “Stress testing is not going away anytime soon, so advanced approaches will likely not factor into constraining ratios near term.”
US banks that are above the Collins floor could still be prevented from reaping capital savings by the Basel Committee’s own capital floor, introduced as part of the final reform package. Under the Basel methodology, banks must hold enough capital to meet 72.5% of all risks calculated using the standardised approaches – including operational risk.
“It’s still unclear as to how the Collins floor will be affected, and how the design of Basel floor will be applied in the US,” says Brad Carr, director of regulatory affairs at the Institute of International Finance. “There is a kind of intricate web of floors that may potentially bind on US banks, so while the intent of the Basel III finalisation was to bring greater certainty, there’s actually some added complexity for US banks at present.”