Ever since the election, a lot of bankers have loudly hummed “Ding-dong, regs are dead, the wicked capital regs are dead.” There is no question that the wicked witch’s demise was warranted, but I’m not so sure about the merits of a similarly-ignominious and total end for the capital rules. As FedFin reports make clear, too much in these proposals is wrong-headed, even as they may now be revised. Still, it’s important also to remember that leaving the current rules unchanged leaves as is many provisions that are anachronistic or demonstrably conducive to shadow banking. There’s never been a better time than now to think about how best to modernize large-bank capital rules without unnecessarily eviscerating large-bank competitiveness. Here are a few ideas to start things off.
As I suggested in Congressional testimony, one of the silliest sections in the August 2023 capital proposal is the double-layered set of standardized approach (SA) credit-risk capital charges. Current rules allow big banks to use the advanced approach to credit risk-based capital (RBC), but banks that do so must hold the higher of their own advanced conclusions or the standardized weight. The proposal gets rid of the advanced approach but still requires banks to pick the higher of two SA options set by the regulators, not advantageous models.
Why have two standardized weights if one of them, while lower than the old weight, is based on what regulators have learned about risk since the old weights were posted in 2013? If the second SA the agencies now propose is wrong, why allow it? Where higher rates now are needed, demand these; where lower weights make sense, again allow them and drop a significant barrier to economic opportunity when it comes to lending for mortgages, small businesses, and other retail purposes.
So, first off, regulators can and should pick one set of standardized credit-RBC capital charges and eliminate the advanced approach for any bank that wants to avoid it while continuing to force banks that use it to pick the higher RBC weight to curb regulatory arbitrage. Because of the unique, continuing approach to credit risk still set for the U.S., there is no need for Basel’s complex output floor, a provision in the global rules designed to catch banks that are elsewhere allowed to rely on the lowest possible credit-risk requirement.
Next, fix AOCI. I was wrong the last time around when I argued that adjusting regulatory capital for unrealized gains and losses was unduly hypothetical, punitive, and volatile. We now know all too well that unrealized losses can turn deadly under acute stress. Unrealized gains are also often hard to measure while losses may be fast, hard, and – see the 2023 crash – fatal.
There’s also a deal to do that would do the market- and operational-risk rules a good deal of good. For one thing, just because a bank isn’t a GSIB doesn’t mean it isn’t exposed to market and operational risk. The current, blanket exceptions need a roll-back.
But, while it makes sense to impose market-risk rules on regional banks, this should be done only when they have a material market-risk exposure. Most don’t have these and thus should not have to conclude complex calculations for minimal exposures. Conversely, specialized or speculative regional banks should capitalize on market risk. Just because a bank isn’t a GSIB doesn’t ensure invulnerability, especially as banking evolves and smaller institutions necessarily become more complex. And the odds that Trump Administration regulators will ease the barriers between banks and nonbanks makes it still more essential to ensure that small, complex banks are carefully capitalized.
I hasten to add that this should not be done as the 2023 proposal would have required – that is unnecessarily complex and in more than a few cases also counter-productive. But the market-risk rules do need a rewrite given the post-2008 understanding of where these risks may arise and how much they can cost.
The same is true for operational risk. As the 2023 proposal rightly states, all banks – not just GSIBs – are exposed to operational risk, risks which have grown only greater in recent years as consumer fraud, cyber-risk, and other hazards proliferate. The proposal’s approach to fee income is rightly set for rewrite and this should be done also for the historical look-back, with the opsrisk rules also revised to focus on plausible but unknown risks, not those also factored into mandatory buffers and other safeguards imposed over the past fifteen years.
Finally, and importantly, a sensible, forward-looking capital rewrite must address a vital issue the banking agencies omitted in their over-complex, under-thought proposal: how the minimum RBC requirements comport, if at all, with the most important capital requirement of them all: the stress capital buffer (SCB). Plugging new capital rules into the old SCB is like trying to charge a smartphone directly in an electric socket. It just won’t work.
The reasons for this capital disconnect are complicated and the cure for them is complex, but the interplay between risk-based capital and the SCB’s stress scenarios and then with the leverage standards cannot be neglected if final capital rules are to be what they must be: forward-looking standards that protect financial intermediaries from severe, but plausible scenarios at cost to shareholders, not taxpayers. Isolating only one capital rule for a rewrite in the capital morass is sure to have dangerous, unintended consequences, but leaving the rules as is without reconciling them all is even worse.