The Basel III capital framework was designed to strengthen the regulation, supervision and risk management of banks in response to weaknesses exposed by the global financial crisis. As the last components of the framework are finalized and implemented around the world, it is critical that this quest for stability in the banking sector is balanced with the need to maintain deep and liquid financial markets. If capital requirements are disproportionately punitive, this will compromise the liquidity and smooth functioning of markets, which will negatively affect economic growth.

It has long been clear that the Basel III ‘endgame’ package of proposed rules, which US regulators published for consultation in 2023, is inappropriately calibrated and would constrain the capacity of banks to offer vital intermediation and risk management services. If the rules are not comprehensively revised, this would have grave consequences for hundreds of thousands of companies that rely on banks to raise financing for growth and investment. From diminished access to funding to a lack of hedging solutions and increased vulnerability to external shocks, it is companies that will suffer the consequences.

That’s why ISDA stands firmly by the recommendations we made to US regulators last year, which were based on the results of a quantitative impact assessment. Those recommendations, which include greater recognition of diversification in the market risk framework to reflect actual risk exposure and changes to certain aspects of the rules for credit valuation adjustment and securities financing transactions, would improve the risk sensitivity of the Basel III endgame and avoid negative repercussions for US capital markets.

It is also vital that regulators take a holistic view of how different rules interact with each other. Capital requirements must not be implemented in a vacuum, without due consideration of how they might affect other regulations and market processes.

Central clearing, widely recognized to be a vital risk-reducing activity, is a good example of this. Unfortunately, ISDA’s analysis has shown that the US Basel III rules and the capital surcharge for global systemically important banks (G-SIB) would increase capital for six US G-SIB client clearing businesses by $7.2 billion, which is equivalent to more than 80%. This punitive tax is completely at odds with the post-financial crisis policy objective to promote greater use of central clearing and would negatively affect market stability. We have set out the steps that are necessary to fix this issue and will continue to advocate for those changes so the provision of vital client clearing services is not compromised.

This comes at a time when the US Securities and Exchange Commission (SEC) is due to introduce mandatory clearing in the US Treasury market from the end of this year. ISDA has been leveraging its experience in derivatives clearing to help firms prepare for this transformational change, but the prudential framework must also be calibrated appropriately.

As it stands, the proposed US capital rules don’t recognize cross-product netting for transactions based on US Treasury securities and interest rate futures. Services like these allow firms to obtain initial margin efficiencies from offsetting trades in a portfolio of transactions, reflecting reduced risk, but there is no commensurate benefit from a capital perspective under the standardized approach for counterparty credit risk. As more Treasury securities and repos are cleared under the SEC rules, the lack of recognition of cross-product netting will constrain bank balance sheets and limit their ability to offer client clearing.

We also think changes are necessary to the supplementary leverage ratio (SLR), which is inconsistent with the objective to improve the efficiency and resilience of the Treasury market, as we pointed out in a letter to prudential regulators last year. The SLR acts as a non-risk-sensitive binding constraint on banks that can impede their ability to act as intermediaries, including their capacity to offer client clearing. We are pleased to hear Federal Reserve chair Jerome Powell acknowledge in testimony to the US House Committee on Financial Services last week that changes are necessary.

There’s no reason why regulators can’t begin work on the SLR, cross-product netting and the G-SIB surcharge now, even before the Basel III endgame is finalized.

These are complex, challenging issues but the stakes are too high for inaction. With a new administration in the US and fresh faces at some of the key agencies, it is vital that policymakers take the time to correct these calibration issues. Deep and liquid markets, which are critical for economic growth, depend on a risk-appropriate capital framework. We must get this right.