Proposed Basel III Rule May Be Another Example of Good Intentions Creating Unintended Consequences

It was only a matter of time.

After depositories such as Silicon Valley Bank and First Republic Bank collapsed this spring, waves of uncertainty swept the banking world and the overall economy. Some loudly called for stiffer capital requirements and tighter bank investment standards in the days and weeks after those occurrences. The Basel III standards, the topic of many a conversation during the Great Recession, were invoked once more.

The Basel III “Endgame” Proposal

Recently, the Federal Reserve, FDIC, and OCC issued what some are calling the “end game” proposal. This proposed rule would materially increase capital requirements for banks with assets of $100 billion. The rule was assembled to address widespread concern about what many considered the root of those bank failures: risky investment practices. An apparent lack of diversity in the failed banks’ investments, in combination with a series of unique economic occurrences (high inflation, the pandemic, etc.) led to a run by their account holders. With their portfolios weighted down heavily by (currently) struggling industries and depressed securities, the banks could not maintain their liquidity in the face of these runs.

Non-depository mortgage lenders would be exempt from this rule because any of the three issuing entities does not directly regulate them. So one might think those in the mortgage banking business who aren’t depositories would be celebrating what could become a competitive advantage in this market.

Think again.

The threat extends well beyond large banks

The MBA’s Pete Mills was quick to author a thoughtful piece discussing why anyone who makes a living in the mortgage industry should be concerned – not just depositories. You can see the entire article here. Along with other concerns; he criticized the lack of an economic-impact analysis to measure the potential for unintended consequences.

Mills also considered the likelihood that credit and loans would be constricted across the board, possibly having a genuine impact on the overall economy. Without that economic analysis, he wondered how much the consumer or business borrower would be harmed. Banks would only be allowed to count 10% of their mortgage servicing rights (MSR) toward Common Equity Tier 1, which could further reduce demand for MSR. The MSR can be a proven revenue stream relied upon by depositories and independent mortgage lenders alike, especially during market volatility. Warehouse lending could also be damaged.

A recent Deloitte study

A recent Deloitte study also noted that the proposed rule could bring residential real estate mortgage risk weights 20 percent higher than international standards.

There’s little doubt that the proposed rule was forged with good intentions. But, as we’ve seen in the past, regulatory changes created quickly in reaction to a disastrous event often have unintended and damaging consequences. There is tremendous potential for that here, too. While few disagree that policymakers should thoughtfully consider ways to discourage unbalanced investment from banks, we should also remember that the system worked (thus far). A string of resulting bank collapses was averted, in part due to the quick reactions of the Fed and some of the same large depositories that the proposed rule would hamstring.

The Role of Private Mortgage Lenders in the Economy

Private mortgage lenders were among the first to lead the mortgage industry back from the results of the Great Recession. That was due, in large part, to the reality that non-banks are traditionally more nimble and were quicker to pivot to the new lending landscape and risk paradigm that depositories took years to adopt to.  We make The American Dream affordable for more people, many of whom wouldn’t qualify for a traditional mortgage from a depository. We play an essential role in the economy, but Basel III isn’t truly a “win” for us.

A slight, temporary advantage might be conferred on non-bank mortgage lenders should the Basel III proposal become law. We don’t question the need to consider ways to help prevent bank runs and failures. But we do ask whether this proposal was fully and thoroughly vetted.