Financial Regulators Warn Against Reducing Bank Capital Requirements

Financial Regulators Warn Against Reducing Bank Capital Requirements

Back in April, the Federal Reserve and the Office of the Comptroller of the Currency (OCC) proposed a regulation that would change the methodology used to calculate enhanced supplementary leverage ratio (eSLR) for global systemically important bank holding companies (GSIBs).

The changes are as follows:

–Replace the current 2 percent leverage buffer that applies uniformly to all GSIBs with a leverage buffer tailored to each GSIB, set at 50 percent of each firm’s GSIB risk-based capital surcharge (GSIB surcharge);

–For covered IDIs, replace the current 6 percent threshold at which such IDIs are considered “well capitalized” under the prompt corrective action (PCA) framework with a threshold set at 3 percent plus 50 percent of the GSIB surcharge applicable to the IDI subsidiary’s GSIB holding company; and

–Make a corresponding change to each GSIB’s external TLAC leverage buffer and long- term debt requirement, and make other, minor amendments to the TLAC rule.

Taking into account pre-stress and post-stress capital requirements, agency staffs estimate that the proposed changes would reduce the required amount of tier 1 capital for GSIBs by approximately $400 million, which is approximately 0.04 percent of total GSIB tier 1 capital as of the third quarter 2017 (emphasis added).

The proposed rule was met with sharp criticism from The Systemic Risk Council in a letter issued earlier this month. From the Financial Times:

The SRC letter argues that, while the regulators’ proposals would have the virtue of harmonising US and global capital rules, lowering effective equity requirements would be dangerous when markets and asset values are at a cyclical peak — the very moment when capital buffers should be the deepest. Furthermore, low nominal interest rates mean that the central banks have less power to stabilise the economy in the case of recession, making strong bank capital more important…

The SLC argues that if the proposals are carried out, they should be accompanied by a requirement that big banks issue an offsetting amount of subordinated debt that converts to equity in the event of losses.

The SLC further argued that this rule is unwise given recent developments in financial regulation, specifically changes made by the recently enacted “Crapo bill,” a lack of Net Stable Funding Ratio for banks, and proposals to relax the Volcker rule.

Given those three developments alone, the Regulators should be strengthening, not weakening, the equity base of banks, and should be doing so in the simplest way, i.e., via the leverage ratio. In the current conjuncture, the Regulators’ proposals would be pro-cyclical.

Essentially, reducing capital requirements in good times has the potential to accelerate booms (and bubbles), but leaves the financial system more exposed to losses and systemic failure in the event of an economic downturn.

The SLC letter recommended that if this policy goes through, regulators should also require financial institutions to issue larger amounts of subordinated debt (obligations to be paid after prioritized lenders have already been paid). You can read more about subordinated debt proposals and contingent capital (which converts debt to equity in the event of a downturn) in our reference library.

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By |2018-08-20T09:20:45-07:00August 20th, 2018|Blog, Financial Regulation|