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US banking regulators should implement provisions originally outlined in the Dodd-Frank Act rather than proceeding with the Basel III endgame proposal, according to Davis Polk Partner David Portilla.

Policymakers have proposed new regulations including higher capital requirements, dubbed the Basel III endgame, aimed at avoiding the scale and cost of bank failures that surfaced during the spring of 2023. Portilla said in the latest "Street Talk" podcast that the easiest policy response is to implement blunt measures but believes the regulatory community could take a more efficient approach by implementing early remediation triggers originally outlined in the Dodd-Frank Act. Those triggers would force regulators to take action to remediate deficiencies at financial institutions when they occur.

"I think the idea was that, to use the Fed's own words, was that the 2009 global financial crisis revealed fundamental weaknesses in the regulatory communities, tools to promptly deal with emerging issues. I think we saw that again in 2023," Portilla said in the episode, recorded Sept. 11.

In a recent article, the regulatory attorney made the case for enacting early remediation triggers proposed in section 166 of the Dodd-Frank Act. That provision directed the Fed to adopt regulations for the early remediation of financial weakness. The Fed outlined four different levels under an early remediation framework but never implemented the rules.

"In some ways, it's back to the future," Portilla said. "You have this really decades of finding the same problem, which is when supervisors have discretion to take prompt and forceful action they hadn't in the past. Therefore, there should be automatic triggers to force them to take action. But again, going back from the '90s to 2000s, 2010s, 2020s, the law was essentially not implemented."

Regulators have responded in the aftermath of the spring bank failures with new capital rules rather than changes in the supervisory and enforcement framework. The new capital rules would subject banks with more than $100 billion in total assets to the enhanced rules estimated to result in a 16% aggregate increase in common equity Tier 1 capital requirements for them. The new rules have faced considerable pushback and ire from the banking industry and its trade groups, which has prompted speculation that the proposal could be watered down or rebooted altogether.

The four levels of early remediation efforts outlined by the Fed more than a decade ago would take a different approach than laid out in the Basel III endgame. Portilla said that first level called for heightened supervisory review after a bank experiences financial distress. The second level calls for initial remediation, which would limit capital distributions, acquisition and asset growth of no more than 5% quarter over quarter and year over year.

The third level calls for a capital restoration plan, broad limits on business activities, and a written agreement with the Fed limiting asset growth, material acquisitions and restrictions on executive compensation. The fourth level would require regulators to start the process of resolving an institution.

Portilla noted that even the Level 2 trigger could have led to a different outcome with banks that failed earlier this year since SVB Financial Group, Signature Bank and First Republic Bank were some of the fastest growing in the industry.

There are other metrics that regulators could use to establish early remediation triggers. For instance, early remediation could be triggered based on deposit outflows, unrealized losses in securities portfolios, or uninsured deposit and industry concentrations reaching a certain level or growing or contracting several times faster than the rest of the industry. SVB was an outlier in the industry on both outflows, unrealized losses in its securities portfolios and uninsured deposit concentration.

"The whole point of early remediation is not maybe we have to go in and take a closer look. But now the law requires us to go in and take a closer look and take these actions," Portilla said.

He further noted that if triggers had been in place related to deposit outflows or unrealized losses in securities portfolios in 2022, bank management teams would have been fearful of hitting the regulatory thresholds. If a trigger was enacted, banks would have faced scrutiny in the investment community, much like if an institution flirts with falling below well-capitalized levels.

"We can't even let ourselves be seen to becoming close to hitting that level because then the investors will know what's coming next. So we're either going to pay up for deposits to keep them or we're going to restructure our balance sheet quickly and swiftly," Portilla said of actions bank managers likely would have taken. "It's not like you get to a world where banks are being closed left and right by the government. You may actually be in a world where the incentives to manage the institution to avoid these triggers become much more stark."