The Federal Deposit Insurance Corp. has failed to adequately explain its rationale behind the July proposal to implement the Basel endgame standards, board member Jonathan McKernan said Wednesday.

The FDIC should focus on ensuring the orderly resolution of troubled banks rather than solely trying to preemptively avert bank failures, McKernan said at an event held by law firm Mayer Brown in New York City.

McKernan voted against the July proposal, suggesting the standards could not provide nonbanks with a competitive advantage by shifting deposits away from the highly regulated, insured banking system.

“I don’t think the solution is to pile on yet more prescriptive regulation or otherwise try to push responsible risk taking out of the banking system,” he said. “Instead, we should try to accept — I mean, truly accept — that bank failures, even large bank failures, are an inevitable result of a dynamic and innovative economy.

“We should plan for those bank failures by focusing on strong capital requirements and an effective resolution framework as our best hope for eventually ending this practiced habit we have developed of privatizing gains while socializing losses,” McKernan added.

Rationale unclear

The rationale behind many Basel reforms is unclear, making them difficult to justify, McKernan said. The regulators' proposal to substitute standardized models for banks' internal risk-weighting models would compel increased capital retention, reducing the funds banks could otherwise lend to generate returns, he noted.

The Basel Committee itself acknowledged that its approach to operational-risk capital could lead to overcapitalization of banks with high-fee revenue. The committee proposed a solution but omitted it from the final standards without explanation. McKernan argued this leaves regulators unable to properly defend an important component of the framework and poses the question of whether the operational-risk capital works for high-fee revenue banks.

McKernan pointed to the profit-and-loss attribution test to explain further. Banks employing internal models to calculate market risk capital requirements use PLA test metrics to evaluate alignment between their risk management and front office models. Based on the test results, each trading desk is categorized as "green," "amber" or "red." A desk in the amber zone has metrics indicating moderate divergence between models, triggering an additional capital requirement called the "PLA add-on." A desk in the red zone would be prohibited from using its models. Therefore, the quantitative thresholds defining this framework significantly impact market risk capital requirements.

“The quantitative thresholds for this traffic light approach really do matter in determining the market-risk-capital requirement,” McKernan said.

Additionally, there is little information in the public domain regarding how the Basel Committee determined these threshold levels.

“I have heard some suggestions that the Basel working groups calibrated these thresholds using simulated data and that the Basel Committee knew it had more work to do here,” McKernan said. “Maybe there’s something to that. But we’re all left guessing here, including even the U.S. regulators.”

McKernan called for regulators to carefully consider and justify their proposals in public.

Long-term debt

McKernan also voiced his concern about regulators proposing banks holding long-term debt.

“We should plan for bank failures by focusing on strong capital requirements and an effective resolution framework as our best hope for eventually putting an end to our bailout culture,” he said. “In the hopes of moving closer toward that goal, I generally supported the proposal to require certain large banking organizations to have, like their [global systemically important bank] counterparts, outstanding a minimum amount of eligible long-term debt with an aim to enhancing the resolvability of those banking organizations.”

One distinctive aspect of the proposal is the requirement for regional banks and certain foreign banking organizations to issue long-term debt from both the top-tier U.S. parent company and the bank subsidiary. In contrast, U.S. G-SIBs must issue long-term debt only from the parent company. 

This divergent approach means regional banks would have less flexibility than U.S. G-SIBs to pre-position resources throughout the banking organization. That, in turn, suggests regional banks may have decreased flexibility and greater challenges in crafting resolution plans that preserve the franchise value of their nonbank operations.

McKernan said he is eager to see how commenters evaluate the risk that this proposal could lock in regional banks' existing structures or even incentivize consolidating more activities into bank subsidiaries — perhaps with the unintended consequence of shielding U.S. G-SIBs from competition with regional banks. 

“We’re more likely to get these proposals right — or at least to get them less wrong — if we hold ourselves accountable for giving our reasons for where we end up,” McKernan said. “To the extent we’ve not done that, I hope commenters will let us know, and also share views on how we should try to fix those gaps, even if that means developing our own U.S. implementation that deviates from the Basel standards in some respects.”