The Federal Reserve’s decision to drop a proposed output floor for bank capital requirements – a key component of the Basel III endgame rules – is gaining support from analysis suggesting U.S. Banks are already realizing limited benefits from using internal models to calculate their risk-weighted assets (RWAs). The move, intended to strengthen the resilience of the banking system, faced criticism from some who argued it would unnecessarily increase capital demands. Now, data indicates the floor may have had a minimal practical impact even if implemented, potentially justifying the regulator’s shift.
The debate centers around how banks determine the amount of capital they must hold against potential losses. Banks can choose between standardized approaches – prescribed by regulators – or internal models, which allow them to use their own data and methodologies, subject to supervisory approval. Internal models often result in lower RWAs, and therefore lower capital requirements, than standardized approaches. However, regulators have long been concerned that some banks may be exploiting these models to underestimate their risk exposure. The proposed output floor aimed to limit the benefits banks could derive from internal modeling, ensuring that their capital requirements weren’t excessively low compared to those calculated using standardized methods.
Limited Gains from Internal Models
A recent analysis, initially reported by Risk Quantum, suggests that U.S. Banks have already seen only modest reductions in their RWAs through the use of internal models. This finding is based on data available as of the end of 2025 and indicates that the potential impact of an output floor would be less significant than initially anticipated. The analysis points to a situation where banks haven’t dramatically lowered their capital requirements through internal modeling, lessening the need for a floor to counteract those reductions.
The Basel III framework, developed by the Basel Committee on Banking Supervision, is a set of international regulatory accords created to improve the regulation, supervision and risk management within the banking sector. The “endgame” proposal represents the final set of reforms stemming from the 2008 financial crisis, aiming to address remaining vulnerabilities in the financial system. The Federal Reserve’s November 2023 proposal outlined significant changes to capital requirements for larger banks, but the output floor was ultimately removed in subsequent revisions.
Why the Output Floor Was Considered
The initial rationale for the output floor stemmed from concerns about the consistency and comparability of capital ratios across banks. Allowing significant variations in RWAs based on internal models could make it tough to assess the true financial health of different institutions. Regulators feared that banks with sophisticated modeling capabilities might be able to game the system, reducing their capital requirements while potentially increasing their risk profiles. The floor was intended to level the playing field and ensure that all banks maintained a sufficient capital buffer.
However, critics argued that the output floor would penalize banks that had invested heavily in developing robust internal models. They contended that these models often provide a more accurate assessment of risk than standardized approaches and that imposing a floor would stifle innovation and discourage banks from improving their risk management practices. Some argued that the floor would increase capital costs, potentially reducing lending and economic growth.
Impact of the Reversal
The decision to drop the output floor has been welcomed by many in the banking industry. Industry groups, such as the Bank Policy Institute, have praised the move, arguing that it will reduce unnecessary regulatory burdens and allow banks to continue to invest in their risk management capabilities. The Bank Policy Institute released a statement applauding the Fed’s revisions, stating they “strike a more appropriate balance.”
However, some observers remain concerned that removing the output floor could weaken the resilience of the banking system. They argue that it could allow banks to continue to underestimate their risk exposure and that it could create incentives for excessive risk-taking. These concerns highlight the ongoing debate about the appropriate level of regulation for the banking sector and the trade-offs between financial stability and economic growth.
The revised Basel III endgame proposal is now subject to further review and comment. The Federal Reserve is expected to finalize the rules later this year, and banks will then have a period of time to implement the changes. The timeline for full implementation is still being determined, but it is likely to be phased in over several years.
Disclaimer: I am a financial analyst and journalist. This article provides information for general knowledge and informational purposes only, and does not constitute financial advice. It is essential to consult with a qualified financial advisor before making any investment decisions.
The next key date to watch is the expected finalization of the Basel III endgame rules by the Federal Reserve later in 2024. This will provide clarity on the final capital requirements for U.S. Banks and the timeline for implementation. We will continue to monitor developments and provide updates as they become available. Share your thoughts on this evolving regulatory landscape in the comments below.
