#holistic capital

In our recent paper outlining the holistic-capital regime regulators should quickly deploy, we noted that current rules are often counter-productive to their avowed goal of bank solvency without peril to prosperity.  However, one acute problem in the regulatory-capital rulebook – procyclicality – does particularly problematic damage when the economy faces acute challenges – i.e., now.  None of the pending one-off capital reforms addresses procyclicality and, in fact, several might make it even worse.  This memo shows how and then what should be quickly done to reinstate the counter-cyclicality all the regulators say they seek.

Last Thursday, the Fed set new, often-higher risk-based capital (RBC) ratios for the largest banks.  The reason for this untimely capital hike lies in the interplay between the RBC rules and the Fed’s CCAR stress test.  Packaged into the stress capital buffer (SCB), these rules determine how much RBC each large bank must hold to ensure it can stay in the agencies’ good graces and, to its thinking, better still distribute capital.

Put very simply, the more RBC, the less RWAS – i.e., the risk-weighted assets, against which capital rules are measured.  The higher the weighting, the lower a capital-strained bank’s appetite to hold it unless risk is high enough also to offset the leverage ratio’s cost – at which point the bank is taking a lot of unnecessary risk to sidestep another set of unintended contradictions in the capital construct.  As a Fed study concludes, all but the very strongest banks sit on their …