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The truth about proposed bank capital rules

September 2, 2023
in Finance
Reading Time: 3 mins read
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The truth about proposed bank capital rules
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The writer is a former chair of the US Federal Deposit Insurance Corporation and former member of the Basel Committee on Banking Supervision

US regulators recently proposed sweeping new rules to strengthen capital requirements for the nation’s largest banks. They are the product of a thoughtful, multiyear process by an international regulatory group called the Basel Committee to refine and improve reforms first undertaken after the global financial crisis. Then, a grossly undercapitalised financial system nearly brought the world economy to its knees.

Unfortunately, there has been misunderstanding around their purpose and effect, much of it fed by industry advocates. The proposals may not be perfect, but it is important for the debate to focus on what they actually do, not mischaracterisations.

Central to the proposals is the virtual elimination of letting banks use their own internal models in setting capital requirements. This so-called internal ratings-based approach failed spectacularly during the financial crisis. Large banks had every incentive to adopt models that understated their risks, as this would allow them to lower their capital requirements to boost equity returns. After the financial crisis, regulators placed limitations on the use of internal models, but they have remained unreliable. The proposed rules would replace them with standardised risk measures determined by regulators.

The proposals would also strengthen capital to protect against operational losses from things such as systems failures, cyber breaches and fraud. Plus, they strengthen capital buffers against market losses in securities and derivatives trading.

Critics have misleadingly characterised the proposals as an overreaction to the recent failures of three regional banks that will disproportionately hurt midsized and smaller institutions. This is simply not true. Their primary impact will fall on bigger, complex banks. Regulators estimate a 19 per cent increase in capital levels for the largest US banks — those with more than $700bn in assets — but only 6 per cent for banks with between $100bn and $700bn. Banks with less than $100bn are not affected except for a small handful that have substantial trading operations.

Critics have also made a tired argument that capital requirements tie up money that banks would otherwise lend. Capital requirements simply govern the ratio of banks’ funding that must come from equity versus debt. Banks can fund a loan with equity capital as easily as with leverage.

In any event, while the proposals raise capital requirements for operational and market risks, they actually reduce them slightly for credit risks arising from lending decisions. Regulators have estimated that most banks already have enough excess capital to comply with the rules, and those that do not can easily retain earnings to meet them by their effective date in mid-2028.

The proposals have been attacked for imposing tougher standards than agreed to by the Basel Committee. But such “gold plating” has long been a competitive strength of US capital regulation, not a weakness. There is one notable exception in which US regulators did embrace weaker standards, and it backfired. They did not require banks with less than $700bn in assets to take into account unrealised market losses on investments available for sale when calculating capital levels. This weakened capital framework made some banks vulnerable to deposit runs when big bets on Treasuries turned sour.

The banking industry has expressed disappointment that the US proposals do not adopt the Basel Committee’s capital requirements for mortgages, which are lower than those currently applied in the US. They argue this will hurt mortgage lending to low-income households. Given massive mortgage defaults during the financial crisis, US regulators sensibly rejected this idea. And in any case, the vast majority of low-income mortgage lending is made by nonbanks which are not even subject to these proposals (and have higher capital levels).

One legitimate concern about the proposals is their complexity. While eliminating the use of internal models helps simplify the current capital framework, the proposals also require larger banks to make two sets of complex capital calculations when a single one based on existing standards would suffice. Hopefully, regulators will find ways to simplify the rules and make them more understandable to the public. But that should not detract from the tremendous public benefits to be derived from this major effort to protect the US and world economies against future financial crises.

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