Anyone who was surprised by Miki Bowman’s ambitious agenda hasn’t been paying attention. The new vice chair for supervision on Friday reiterated much she’s said before about supervision and regulation, now also saying more specifically what she’ll do about it given that she’s in a position to do it. Much in her plan is heartening, but one proposal is break taking in both its simplicity and importance: Ms. Bowman wants to make the complex of big-bank capital rules make sense as a whole. Former Vice Chair Barr promised to do this when he was confirmed, but he instead proposed only to complicate the capital construct. Ms. Bowman might just put it right.
As we laid out when Mr. Barr promised a “holistic” capital policy, the current approach pulls in at least three directions, and that’s before one starts thinking about unintended consequences related to liquidity and interest-rate risk. First, there are the risk-based capital (RBC) standards designed to capture the credit risk of every asset and exposure, sometimes more than once based on which numbers come out how. Not content with that much complexity, Mr. Barr and other regulators in 2023 proposed a “dual-stack” approach to credit risk largely because, we concluded, they couldn’t make up their minds which one was right. Then there are standards governing market and operational risk – some forward-looking, some retrospective, and some stuck in the middle distance.
There are also leverage rules designed to capture assets deemed to pose no credit risk even though the leverage standard assumes it that could somehow come back and bite a bank. These standards now are topped off with a supplementary leverage ratio (SLR) for most banks and an “enhanced” – read higher – SLR for the biggest, with two eSLRs imposed because the FDIC and Fed couldn’t agree on the right number. Lurking below all these cross-eyed standards is the Collins Amendment in the Dodd-Frank Act stipulating that nothing new can be easier than the old standards even though these blew up in 2008 and are essentially irrelevant given modern banking markets.
But wait – there’s more. There are also stress tests, with the most important of these being the Fed’s governing the largest bank holding companies. The results of these stress tests determine capital adequacy despite all the other rules even though they have missed most of the severe stresses evident as recent years rolled by. Stress-test capitalization also feeds into another calculation designed to come up with a stress capital buffer (SCB) which sets the final tally a big bank must hold.
Or, it does if the bank isn’t a global systemically-important bank (GSIB). For them, fear not – there’s also a GSIB surcharge just in case none of the rest of the capital charges suffices or, perhaps, just to punish huge banks for being harder to resolve than the FDIC has yet to fathom even though Congress told it in 2010 to do so.
I got tired just writing all this, but that’s nothing to calculating all these capital requirements and then, as bank CEOs must, figuring out what they mean in terms of competitiveness, products offered, customers served, and markets left behind. Regulators somehow think banks can magically meet all these requirements without making any strategic assumptions; in fact, banks that want to stay in business model their activities and exposures to arbitrage the rules to the greatest possible advantage in hopes of at least holding their own against powerful, aggressive competitors sensibly outside the reach of the banking regulators. The banking agencies bemoan NBFIs, but whose fault are they?
There is clearly capital chaos, but one reason for this is supervisory incompetence. It should be possible to set a simple capital ratio and maybe stress test it and then leave it to supervisors to add on more capital charges if one or another bank looks dodgy. Every capital rule I’ve ever read reserves power for a supervisor to do so based on an individual bank’s profile. In practice, this never occurs until supervisors issue an enforcement order and, as we learned yet again in 2023, that’s too late.
Vice Chair Bowman and the Treasury Department have big plans for better bank supervision and more power to them. However, even they don’t seem to trust themselves enough to get supervision strong enough to sanction under-capitalized institutions without resorting to at least some add-on capital charges. That’s more than too bad, but it’s also likely too true.
So, what to do? I am a big fan of a new approach called “economic capital” in which capital requirements are set based on an assessment of GAAP-calculated capital, liquidity, and market capitalization. It is, though, too soon to know how best to calibrate this construct, stress test it, and then run a careful exercise in which different banks are modeled under possible approaches and stress scenarios. Given this, one near-term fix is for agencies formally to acknowledge the importance of market capitalization as a critical early-warning signal and then announce that banks with book values below asset value will come under a new surcharge. This is simple and makes a lot more sense than just penalizing banks because they’re big. If GSIBs are too complex or otherwise impossible to resolve under another conflicting post-crisis standard demanding credible resolution plans, then the agencies should yet again use their supervisory powers and break them up. Capital penalties vanish in a crisis; resolution plans thus must be credible or the bank will be forcibly redesigned.
And yes, it’s time to eliminate the SLR for short-term Treasury obligations and central-bank deposits and eliminate the size-related add-on of the “enhanced” SLR. Make the SLR make sense and then be done with it. Similarly, make the credit RBC rules make sense by setting one set of standardized charges, eliminating market-risk gold-plating, and omitting operational-risk capital standards if agencies can’t figure out how to make them forward-looking.
Going as far as I propose is farther than comfort-seeking agencies may be willing to go. Still, it’s worth trying hard to force the agencies to think big, go simple, and then get tough.