The Fed Must Reject Stealth Cut of Bank Capital Requirements

By | December 5, 2019

Courtesy of Gregg Gelzinis

In a recent speech, Federal Reserve Vice Chair for Supervision Randal Quarles again publicly outlined his plan to engineer yet another decrease in the loss-absorbing capacity of the nation’s largest banks. The plan would re-design the countercyclical capital buffer (CCyB) and use misdirection to make it appear as though there would be no impact on bank capital levels. Though Quarles’ desired changes involve the complex machinations of the bank capital framework, the end result is simple. Over time, big banks would have lower loss-absorbing equity cushions—increasing the vulnerability of the financial system and leaving the economy increasingly exposed to the risk of another crash.

The CCyB was created in the wake of the 2007-2008 financial crisis as a mechanism through which bank capital could be raised when the economy is booming, and risks are building. As the old adage goes, “The worst loans are made during the best times.” The increased capital buffers could then be deployed by banks to absorb the above-normal losses that come with the eventual turn in the business cycle. Many current and former policymakers have called for the Fed to activate the CCyB now, given elevated asset valuations, high levels of corporate debt, and deteriorating credit quality of corporations taking on that debt. The core banking system is both directly and indirectly exposed to these risks.

The central element of Vice Chair Quarles’ plan is to activate the CCyB, while making two changes to bank capital requirements that would lower capital—offsetting the increase caused by the CCyB. First, this change would cast aside the whole point of raising the CCyB at this moment in the cycle. If the CCyB is activated now, the end result should be higher bank capital levels, period. There is no financial stability benefit to raising the CCyB if the overall loss-absorbency in the banking system remains the same. Second, and more importantly, activating the CCyB under this scheme creates the opportunity for regulators to seamlessly reduce capital later. If the Fed sets the CCyB at 1%, while reducing capital by one percentage point elsewhere, the Fed can then lower the CCyB by 1% later. The decision to turn down the CCyB later, without raising it today, would leave capital lower than it is now. The conceptual underpinning of this CCyB plan has been used in other countries, including the U.K., but the appropriate measure of any plan is the current and potential future impact on bank capital levels within the U.S. capital framework. Vice Chair Quarles’ plan is a stealth cut that amounts to a capital requirement trap door. No immediate impact, until the door is opened later.

It is particularly concerning that Vice Chair Quarles has repeatedly sought to reduce bank capital requirements when a strong body of research suggests that, while improved since the crisis, bank capital levels are still at the low end of the socially optimal range. Regulators should be improving the resiliency of the financial system instead of using creative levers to erode it.

In his speech, Vice Chair Quarles anticipated this critique and claimed that he’d be as likely to raise the buffer, as he would be to lower it going forward. That claim rings hollow given his track record on the CCyB. He voted against activating it in March, despite the strong evidence that risks are building in the financial system as the economy moves towards the end of the business cycle. Moreover, it’s difficult to trust that he would strengthen regulatory safeguards in the future when he has worked to weaken a host of post-crisis rules throughout his tenure.

Perhaps expecting pushback to his CCyB plan, externally and internally, Vice Chair Quarles said that raising a separate risk-weighted capital requirement floor could be an alternative option to offset the decrease in capital caused by the other changes he’s seeking. It remains to be seen whether this floor would be calibrated high enough to sufficiently offset the expected reduction in capital elsewhere. But there is a fundamental flaw with the alternative. Part of the decrease in capital that needs to be offset flows from Vice Chair Quarles’ conceptually-dubious wish to eliminate all leverage requirements from the Fed’s 2018 stress capital buffer (SCB) proposal. Increasing a risk-weighted requirement to offset a decrease in capital partially caused by a relaxation in leverage requirements could lead to an effective decrease in capital over time. Banks constantly seek to optimize their risk-weighted assets to lower their capital requirements through financial engineering or by generally shifting their balance sheets towards assets that receive lower risk-weights. As banks engage in this capital arbitrage behavior, they would be able to reduce their capital levels further before bumping into the weakened risk-neutral leverage complement that is more resistant to gaming. This change would be consistent with regulators’ efforts to chip away at other big bank leverage requirements.

As former Fed Governor and financial regulatory czar Dan Tarullo recently stated, “Capital requirements for the largest banks should be going up, not down.” Unfortunately, from bank capital requirements to living wills and liquidity rules, Trump-appointed regulators are deregulating the largest banks at exactly the worst time. Wall Street will enjoy higher profits and larger shareholder payouts today, while workers, families, and the broader economy will bear the brunt of a destabilized financial system tomorrow.

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