Few, if any, regulatory agencies are omniscient. More than a few think they are, but more often than not regulators who fail quickly to see the error of at least some of their ways are regulators who lose a lot more than they might otherwise have lost. Which brings us to the capital proposal and what next befalls this troubled standard after Michael Barr’s belated recognition that something had to give.
In the near term, we’ll see action by the FRB, FDIC, and OCC to clear a revised proposal along with the Fed’s quantitative impact survey for another round of public comment. I have to believe Fed Vice Chair Barr cleared the revisions he previewed last week with his allies at the OCC and FDIC and is confident that the Fed board will mostly agree with him up to the point of issuing a reproposal, if no further. As a result, a reproposal Mr. Barr said will amount to about 450 pages will soon be upon us.
Is this the last word? Having relearned humility the hard way, Mr. Barr promises it is not. What else might have to change to get a final U.S. version of Basel’s end-game standards across the goal line?
I would guess a lot more than would have been the case had the Fed and other tough-rule advocates more quickly recognized policy and political reality. One key, if seemingly-technical, point on which to give is the pesky “output floor.” Basel imposed the output floor because it allows nations to use advanced approaches to calculate credit risk as well as key points in the market-risk rules and then pick the lower of the standardized or advanced approaches. The U.S. has long required large banks to take the higher of the standardized or advanced approaches, eliminating the arbitrage opportunity EU banks and several others used to considerable, if risky, advantage.
Further, most foreign banks operate under far less stringent leverage ratios than those mandated for the largest U.S. banks. For most of these banks, risk-based capital, not leverage, is the binding constraint. In the U.S., incentives to hold low-risk assets, assets key to liquidity resilience, are caught under the 2023 proposal not only by the output floor, but also the base leverage requirements also meant to prevent the arbitrage opportunities allowed elsewhere by risk-weight games.
An output floor makes sense where banks can pick the risk-weighting they like under liberal leverage standards. But, as we said last year, it makes no sense to have an output floor in the August 2023 U.S. proposal because it generally banned model use and left leverage ratios untouched. An output floor in the revised rule might make some sense, but only if it’s dramatically adjusted from the proposal and deals with the “dual stack.”
The 2023 proposal also included a particularly-bewildering approach to credit risk, creating a “dual stack” of alternative standardized risk weightings while keeping all the old ones among which banks could pick. This is apparently still in the new approach. Why then an output floor? If the agencies think their revised weightings make sense, why still require an output floor governing credit risk? If it’s in the new proposal, any bank that wants to use the new weightings the agencies thought made sense in 2023 and still others Mr. Barr now recommends are a waste of everyone’s time when it comes to the regulatory-capital bottom line. Regardless of weighting optionality, a floor above weightings set by the agencies themselves – not self-interested models – will have the effect of forcing banks to optimize capital by picking between low-risk assets and then adding enough high-risk ones with high capital requirements to come above the floor. Does that make sense? Of course not.
How the output floor and dual stack are recrafted, if at all, is key to what banks will think of the temptations Mr. Barr tossed their way with reduced weightings for certain mortgage and retail exposures. If the floor stays high, then the new weightings will not matter for any bank with big positions in these assets, meaning that banks will reduce them and sink even farther out of sight in key retail and corporate financial markets where the rules under which banks operate are key to consumer protection and community development. They will not go peaceably, nor should they.