Credit and Capital: 2023 Regulatory Challenges

Capital shifts

The federal banking agencies (FRB, OCC, and FDIC) have indicated they will examine capital tools and how those tools support the resilience of the financial system, both at individual financial institutions and in combination. The FRB has stated that when calibrating capital requirements, the agencies will work to “minimize unintended consequences, limit opportunities for gaming, and avoid excess compliance costs that do not result in risk reduction.”

Capital changes being considered for large banking organizations include:

• Potential adjustments to the supplementary leverage ratio, countercyclical capital buffer, and stress testing as part of an “holistic review” of the capital framework to ensure that it “evolves with new and emerging risks and remains responsive to macroeconomic conditions, market structure, and financial activities.”
• Increased demand for supplementary analysis and runs.
• Enhanced regulatory capital requirements to align with the final set of Basel III standards, commonly referred to as “Basel IV,” issued by the Basel Committee in December 2017. A proposal is expected to be released early in 2023 with implementation of final rules anticipated for January 2025.

In addition, persistent inflation, recessionary trends, and changing interest rates could drive strategic capital shifts, pushing companies to consider:

• Robust and dynamic rate analysis to changing rate environment and economic indicators.
• The use of analytics to guide decisions while considering fairness and impacts (e.g., lending impacts of higher interest rate environments to vulnerable populations).

Credit risk sizing and concentration

Changing economic conditions and the ability of the financial service sector to quickly measure, assess and factor changes into business processes will be a continuing focus for the regulators relative to credit risk sizing and concentration risks.  Specific areas of focus will include:

• Climate Risks: Increasingly robust quantification of financial and non-financial climate risks (consistent with stress testing and capital models/standards).
• Concentration Risks: Portfolio concentrations deemed potentially “higher risk”, including CRE (notably office space, hotels, retail), leveraged lending, and digital asset holdings.
• Off-balance Sheet Risks: Reassessment to areas such as unfunded loan commitments, lines of credit, credit derivatives, foreign exchange, and cash management services.
• Subprime / Vulnerable Populations: Impacts of decisions around credit, servicing, and collections across consumer groups, inclusive of credit decisioning, pricing, servicing, collections, and exceptions management.

Effective compliance

Regulators will be looking for companies to demonstrate compliance on several examination priorities, including LIBOR conversion, resolvability, and liquidity.

• LIBOR: Given upcoming LIBOR cessation dates, companies should anticipate an increase in examinations and enforcements.
• Resolvability and resolution planning (or “living wills”), including:
  • New focus on resolvability of domestic systemically important financial institutions (DSIBs), including consideration of more stringent requirements.
  • Enhanced supervisory expectations (FRB and FDIC).
  • Increasing examination findings and enforcement.
• Liquidity, including:
  • Adequacy of liquidity position, and the effectiveness of risk management and stress testing.
  • Reporting, stress testing, and early warning indicators.