Basel III Overhaul: Banks Poised for Mortgage Growth as Capital Rules Ease

Federal regulators are considering significant revisions to the Basel III capital rules, potentially unlocking mortgage growth and shifting activity back towards the banking sector. The proposed changes, spearheaded by Federal Reserve Vice Chair Michelle Bowman, aim to recalibrate the treatment of residential mortgages and mortgage servicing rights (MSRs), addressing concerns that stringent capital requirements have pushed lending activity outside of regulated banks.

Easing Capital Requirements for Mortgages and MSRs

The core of the proposed overhaul centers on reducing the capital burden associated with holding mortgages and MSRs. Currently, under Basel III, MSRs are subject to strict limits, requiring banks to deduct amounts exceeding 10% of Common Equity Tier 1 (CET1) capital, and even more stringent deductions if MSRs, deferred tax assets, and investments in unconsolidated financial institutions collectively exceed 15% of CET1 . The proposed changes seek to alleviate these restrictions.

Specifically, regulators are considering eliminating the capital deduction for certain MSRs, instead assigning them a 250% risk weight. The Federal Reserve is seeking feedback on whether this risk weight is appropriate . This shift is intended to incentivize bank participation in mortgage businesses while acknowledging the inherent uncertainties in realizing value from MSRs over the economic cycle.

Risk-Based Approach to Mortgage Lending

Beyond MSRs, the proposed rules also introduce a more nuanced, risk-based approach to residential real estate exposures. Risk weights for mortgages would be tied to loan-to-value (LTV) ratios, ranging from 20% for loans with a 50% LTV to 105% for those at 100% LTV but not dependent on real estate cash flows . This aims to better reflect the actual risk associated with different mortgage products.

Impact on the Banking Sector

The proposed changes are expected to have a varied impact across different bank sizes. The revisions could reduce Tier 1 capital requirements by 4.8% for the largest banks (Categories I and II), 5.2% for Categories III and IV, and 7.8% for smaller institutions . This increased capital flexibility could encourage banks to increase mortgage origination and servicing volumes.

Industry groups have largely welcomed the move. The Mortgage Bankers Association (MBA) stated the proposal “incorporates several priorities long advocated,” including more risk-sensitive capital treatment and less punitive rules for MSRs and commercial real estate . A coalition of five trade groups – the Consumer Bankers Association, Bank Policy Institute, American Bankers Association, Financial Services Forum and National Bankers Association – also praised the proposal, suggesting it could support lending and economic growth.

Dissent and Next Steps

Not all policymakers are in agreement. Fed Governor Michael S. Barr voted against the proposals, deeming the capital reductions “unnecessary and unwise” . Despite this dissent, the proposals are moving forward, with a comment period open until June 18, 2026.

The potential shift in capital rules comes after a period where banks’ share of the mortgage market has declined. In 2008, banks accounted for roughly 60% of mortgage originations and 95% of MSR ownership. By 2023, these shares had fallen to approximately 35% and 45%, respectively . Regulators hope these changes will encourage banks to reclaim a larger role in the mortgage market, bringing lending activity back under tighter regulatory oversight.