US banking regulators are back to their old tricks. In the wake of a crisis — this time the March demise of a handful of regional banks — they want banks to fund themselves with more loss-absorbing equity capital.
No doubt, capital is a key element of resilience. But there are better ways to strengthen the financial system.
The Federal Reserve’s proposal focuses on banks with $100 billion or more in assets. It has three major components, all of which will make regulatory capital standards harder to meet. It will impose standardized measures of credit risk, rather than allowing banks to use internal models. It will toughen assessments of market risk, by reducing the estimated benefit of diversification across different trading businesses. It will increase the amount of capital required to compensate for operational risk — for example, the risk of business outages or legal liabilities created by operational problems.
All told, the changes would boost capital requirements for the biggest banks by nearly 20%, or 2 percentage points of risk-weighted assets. They come on top of the large increase that followed the 2008 financial crisis — an overhaul that included added requirements for systemically important financial institutions, calibrated to their size, complexity and interconnectedness. As a result, US banks would have capital requirements well above those set by the Basel III global standard.
Does this make sense? I see three considerations. Does it strike the right balance between resiliency and the cost and availability of bank credit? Will it make the entire financial system stronger, or instead push activity away from banks into less-regulated entities? If the goal is stronger banks, is this the best way to achieve it?
On the first question, Fed Chair Jerome Powell has acknowledged that higher bank capital requirements will make credit more expensive and less accessible. Equity costs more than deposits or subordinated debt, so banks and their securities units will pass that on in the form of higher lending rates, higher trading costs and reduced market liquidity. It’s hard to see how the benefit of greater resilience will outweigh such costs. The four largest US banks, which account for more than half of all the country’s banking assets, are already quite sound. During the most recent crisis, depositors ran to them.