Banks Urge End to Dual Capital Rules, Seek Single Risk-Based Standard

Banks are calling on regulators to forgo the two-track system of capital. They have been asking for a single, risk-based standard to replace it. The current setup requires them to hold excess funds that hinder lending.

Four regional banks told federal regulators (the Fed, FDIC, and OCC) that redundant rules divert funds that could otherwise be tapped for loans. The four banks are Capital One, PNC, Truist, and U.S. Bancorp.

They argue that U.S. rules over-capitalize risk. They cite the overlap between stress tests and minimum standards. Banks refer to this as U.S. gold-plating — domestic rules add layers that increase capital requirements beyond the Basel framework. That raises capital above global norms.

It also limits competitiveness. Banks want a single rulebook that matches global standards. Regulators are now revising the 2023 proposal. Full implementation should occur next year.

The Case for Simpler Rules

Large banks now measure capital in two ways. The standardized approach uses preset risk weights. The advanced one uses bank data to measure risk. Basel III standards assign 0% risk for Treasuries but up to 100% for corporate or subprime loans. Riskier lending, like subprime credit cards or auto loans, requires more capital.

Supporters say one approach will cut duplication. In addition, it will free billions in capital and make compliance easier. Smaller and midsize banks could also cut costs.

The American Bankers Association says this will align U.S. banks with global rivals. But until rules are final, banks are holding extra capital. That caution trickles down to subprime lenders. They will have to plan conservatively or limit growth.

Effects on Subprime Lenders

A single risk-based system will change subprime lending. These lenders serve weaker-credit borrowers, so higher risk weights mean more capital for each loan. Lenders may raise rates if those weights increase. They will also have to tighten standards and/or shrink portfolios. To cut costs, many lenders will move to safer borrowers.

The four banks argue that current U.S. rules over-capitalize risk, yet smaller firms worry changes will only favor larger banks.

Smaller firms are worried that tighter rules will favor big banks. The large banks may enter subprime markets and crowd out specialists. Simpler rules for smaller lenders could help if regulators decide to keep those breaks in place. However, they will face higher costs — if regulators demand more detailed risk data. 

Funding could tighten, too. Investors in subprime portfolios will ask for higher yields if they see higher capital costs. That will push up APRs. It will also lower limits and reduce approvals.

How Prices and Access Could Change

Subprime loans saddle lenders with more risk. So they will have to hold more capital. Higher APRs and fees often flow to borrowers. Some lenders will cut lines and reject more applicants. Many lenders will finance their loans via warehouse lines and/or asset-backed deals. Funders will seek bigger returns if the rules jack up risk weights.

Competition could shift as well. Large banks will probably expand their subprime lending since they will have lower capital charges. Smaller players could struggle to compete. That is, unless tailoring gives them relief.

What to Watch Next

Regulators will have to choose one of two paths. A one-stack plan would drop the advanced approaches. It will bring the U.S. closer to Basel rules. But that could raise capital needs by about two percentage points. It will also double-count some risks already captured in stress tests.

Alternatively, a simplified two-stack plan will keep both systems. It will update one to match the final rules from Basel. The current stress capital buffer will be preserved.

The Bottom Line

Simpler rules will free up capital. A greater amount of lending should follow. But subprime lenders will feel the biggest impact. Those with strong analytics and risk controls will gain, but only if regulators set risk weights fairly.

Other lenders will be staring at higher costs as well as stricter oversight. Stability and competition will determine credit flows in subprime markets.