#SCB

21 04, 2025

Karen Petrou: The Fed Just Puts Ribbons on Rags

2025-04-21T09:14:50-04:00April 21st, 2025|The Vault|

Four months after announcing plans for minimal changes to its stress tests, the Fed last Thursday screwed up its courage and proposed a couple of them.  The remaining, still-small changes will come after the Fed rests up, but none of this seemingly-strenuous effort addresses the fundamental problem with both capital regulation and the testing designed to ensure it suffices:  none of these rules make total sense on its own and all of them taken together are a cacophony of competing demands and ongoing collisions with other standards.  Prettying up the stress-test rule is thus only putting ribbons on a ragged assemblage of ill-fitting pieces in clashing colors with large, large holes.

Now-ousted VCS Michael Barr promised a “holistic” capital construct during his 2022 confirmation hearings, but he nonetheless clung tightly to one-off rulemakings without any cumulative-impact analysis.  Mr. Barr thus opposed last week’s stress-test changes, but for all the wrong reasons.  He thought they went too far; in fact, they don’t go anywhere near as far as they could and should.

The new stress-test proposal most substantively says that banks will henceforth be judged by a three-year rolling average of their tested capital levels, rather than on the current, volatile annual schedule.  But, averaging numbers that don’t make sense tells one nothing about the utility of each test.  Think about a household with two chihuahuas – average dog weight about ten pounds.  Next year, a Labrador romps in, and the average goes up, but the yard can still hold three …

17 03, 2025

Karen Petrou: A New, Unified Theory of Effective Bank Regulation

2025-03-17T09:13:31-04:00March 17th, 2025|The Vault|

There is one perennial, overlooked, and devastating irony in the vast body of bank capital and liquidity regulation:  the better a bank’s liquidity score, the less regulatory capital it has.  Although liquidity and capital are inexorably linked when it comes to preserving bank solvency, the need to comply with two contradictory standards forces banks to change their business model to meet both ends in the middle at considerable cost to profitability and long-term franchise value.  This is of course a major threat to solvency of which bank regulators are either blissfully unaware or, worse, heedless.  Federal banking agencies have stoutly refused to undertake the essential cumulative-impact analysis we’ve fruitlessly urged on them most recently in Congressional testimony.  A new Federal Reserve Bank of New York study shows not just why they should judge rules by sum-total impact, but also how they could do so and thereby have a much better sense of which banks might actually go broke before they do.

I refer you to the full FRB-NY paper for details.  It crafts an economic-capital construct calculated by netting the net present value of financeable assets versus par liabilities as a baseline measure which can then be tested under various stress scenarios that start with illiquidity and end in insolvency and vice versa.  This leads to a robust measure of survivability that combines the impact of credit risk, liquidity, and the real-world market conditions current rules ignore.  In essence, economic capital is derived from the hard-nosed, real-time factors that wise …

12 11, 2024

Karen Petrou: Why Banks Should Want New Capital Rules

2024-11-12T12:02:42-05:00November 12th, 2024|The Vault|

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 …

17 07, 2023

Karen Petrou: Counter-Cyclicality is One Critical Missing Piece of Barr’s Unholistic Construct

2023-07-17T16:55:22-04:00July 17th, 2023|The Vault|

Banks and Republicans are beating up on Michael Barr for much in his new capital construct.  The furor focuses on the high cost of the new capital rules, cost glossed over in Mr. Barr’s talk via an over-arching assumption that banks can readily do without two years of post-dividend retained earnings.  Maybe they can; investors not so much.  This is a big problem, but a little-noticed one also warrants more scrutiny:  the decision to leave untouched and apparently not even considered the U.S. version of the counter-cyclical capital buffer (CCyB).  This makes the new framework still more procyclical and even less holistic.  CCyBs have worked well around the world and a well-designed one in the U.S. would obviate the need for some – not all, but some – of Mr. Barr’s most counter-productive ideas even as it makes banks more resilient, the financial system safer, and the economy less volatile.

What are CCyBs?  The basic idea is that these are capital charges triggered in good times that are released under stress, making banks and the economies they serve better able to ride out macroeconomic boom-bust cycles.  The final U.S. version of the global CCyB framework acknowledges this global standard, but it goes on to say only that the Federal Reserve will know a boom or bust when it sees it and will do something about it via some sort of CCyB should it feel inclined to do so possibly after a rulemaking process on the up- and down-sides that …

8 08, 2022

Karen Petrou: Procyclical Capital Rules and the Economy’s Discontent

2023-01-04T13:14:40-05:00August 8th, 2022|The Vault|

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 …

11 07, 2022

Karen Petrou: Holistic-Capital FAQs and Some Priority Answers

2023-01-24T15:15:17-05:00July 11th, 2022|The Vault|

Late last week, we released a new issue brief laying out how to quickly take Michael Barr’s suggestion of a holistic regulatory-capital regime from rhetoric to reality.  The American Banker did a fine job summarizing the paper and putting it into the policy context, generating a lot of questions to which I’ll turn in this memo.  By far the most common assertion is that this paper is a stealth big-bank campaign to cut regulatory capital.  If it is, that’s news to all of them, as they saw the paper about the same time the Banker article appeared.  More to the point and as I’ll discuss below, a holistic-capital regime wouldn’t come cheap, it would just be better honed and more effective.

The paper was sparked by what might have been an offhand comment from Mr. Barr at his Senate confirmation hearing for the Fed’s supervision vice chair.  He was asked his views on the “Basel IV” package of regulatory-capital rewrites and said that he favored thinking about capital as a whole rather than finalizing individual standards in the absence of a broader vision.  Or that’s what he seemed to mean because, sensible man that he is, the less said at a confirmation hearing, the better, and talk quickly turned to other matters.  Assuming he meant what we thought he said, FedFin did our best to give it legs.

We did so in part by providing a short taxonomy of key capital requirements showing how they relate to other capital requirements …

17 12, 2021

FedFin: Building Buffers

2023-05-22T15:57:33-04:00December 17th, 2021|The Vault|

As noted on Thursday, FHFA continues to tread carefully through the big-bank rulebook, adopting standards said to be like-kind that aren’t quite so similar when it comes to critical details.  The latest proposal demands capital planning in a construct akin to the one Democrats favored as the agencies finalized the big-bank stress capital buffer (SCB) minus express restrictions on capital distributions.  Although the SCB will make Fannie and Freddie more resilient, it also steepens the climb out of conservatorship unless some new capital comes along.

The full report is available to subscription clients. To find out how you can sign up for the service, click here.…

15 09, 2021

FedFin on: GSEs Get a New, If Familiar, Gig

2023-08-03T14:58:42-04:00September 15th, 2021|The Vault|

As noted yesterday, Treasury and the FHFA pulled the Trump PSPA’s plug, although importantly and widely overlooked is that this is true only when it comes to near-term asset-purchase considerations.  Still, with this action atop all the others redefining Fannie and Freddie since Sandra Thompson took over, the GSEs are being reconfigured into agents of Administration policy in concert with being still more critical agencies for housing finance.

The full report is available to subscription clients. To find out how you can sign up for the service, click here.…

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