After the Fed meeting on Wednesday, some of the reactions might have led one to think that the banking agencies had broken into a lost tomb, destroying vital artifacts of a holier time in the days of Dodd-Frank.  The uproar over the proposed limitations on the advanced internal-ratings based (A-IRB) capital standards made me think of an ark that, if touched, destroyed the banking system as our ancestors sought to create it.  In fact, the ark of A-IRB deserves excavation – as we showed in a 2017 study it has an array of unintended effects on non-complex, regional banks.  Where the agencies may, though, be entering at risk is in the broader scope of their proposals.  I fear that, just as they created the post-crisis framework with little thought of the interactions among all the rules, they are now dismantling it without a clear vision of what is really needed to safeguard a large financial-services firm.

In our A-IRB paper, we put the advanced approach in the broader context of all of the prudential rules governing the large, non-complex banks that would benefit so handsomely from the Fed and inter-agency proposals.  This included all the other capital rules governing these banks – count them into the dozens, the liquidity framework, governance standards, stress tests, supervisory authority, and – most important in my view – resolution requirements.

The A-IRB showed itself to be a flawed standard for institutions with small books of highly-complex derivatives, minimal trading books, or few other indicators of high-risk, idiosyncratic exposure for which the A-IRB is designed.  We also showed that the arbitrage risks evident in other nations – using zero-weighted assets under the standardized approach to amass high-risk books – is virtually impossible in the U.S. due to the tough leverage ratio and – also virtually unique to the U.S. – meaningful stress tests and economic-capital allocation and model-validation rules. 

Even more interestingly, we found a lot of authoritative research from global central banks, the Fed, and other objective sources showing structural risks directly attributable to the A-IRB.  At a time when CECL is about to be upon us, the clearly procyclical incentives generated by A-IRB are especially worrisome.  These are particularly pronounced for institutions which hold concentrated portfolios of single assets – e.g., mortgages, credit cards.  Even worse, the A-IRB, especially when paired with CECL, may stoke systemically-significant procyclicality given the correlation across the large-bank business models due to overall capital incentives to hold like-kind high-risk assets.  Requirements in the A-IRB to use the “AOCI filter” were singled out by Gov. Brainard as a critical safeguard, but recent Federal Reserve Bank of New York research shows its strongly procyclical impact.

Public commentary on the end of A-IRB also bemoans the proposal on grounds that big banks would be allowed to hold lots less capital.  Really? A GAO report to Congress in 2014 concluded that it is simply not possible to determine if the advanced approach results in more and/or better disciplined regulatory capital than the standardized approach.  A more recent GAO study went farther with regard to just one asset class – mortgages – but found little difference between standard and advance requirements.

Further, is the post-crisis capital framework with or without the A-IRB really a talisman that wards off all systemic evil?  A global survey of academic literature on regulatory capital found that, “In conclusion, both theoretical and empirical studies are not conclusive as to whether more (stringent) capital (requirements) reduces banks’ risk-taking and makes lending safer.”  A more recent paper from the Federal Reserve Bank of San Francisco looking at data from seventeen countries from 1870 to 2013 finds that higher capital (at least as measured without reference to risk) not only does not promote financial stability, but also may make financial crises more likely.  There is also plenty of research showing that higher capital does not drop the cost of capital as regulators anticipated but has a significant, direct, and negative impact on credit availability.

What do we really know about all the new rules?  A 2011 study we released anticipated a raft of unintended consequences from the complex post-crisis framework, many of which have proven to be problems with which regulators are only now beginning to reckon.  As they do so, the U.S. is dismantling not only aspects of the rules such as the A-IRB that do little good for all their cost, but also the liquidity, risk-management, and – the Fed and FDIC announced on Wednesday – the post-crisis resolution-planning requirements.  Are we just dismantling the post-crisis framework as heedless of interactions and market forces as we were when it was put into place?

Indeed, do we even know what we really want of big banks?  Bulwarks against crisis no matter what?  Engines of growth?  Drivers of economic equality?  Effective transmission channels for monetary policy?  Or, perhaps, just the increasingly disintermediated sector that regulated banking is proving itself to be?  Eight years after the crisis, regulators don’t seem to know beyond demanding that banks never fail. 

The fact is, though, that banks will always fail – if they’ve got lots of capital, they may fail due to liquidity risk.  If they’ve got lots of capital and liquidity, then operational risk might strike them dead.  If they’ve got lots of capital, liquidity, and operational resiliency – a walloping big if – then industry or systemic correlation could do them in. 

What we really need is not bullet-proof banks – a hopeless cause that turns banks into utilities along the way at cost to economic equality and macroeconomic growth.  Instead, what we should demand of banks large and small – not to mention also non-bank financial institutions – is that failure cost no one dearly other than shareholders and senior management.  Ten years on, that’s a promise we still can’t keep.