Dereg Now, Dereg Whenever (Apr. 25)

Update 266 – Dereg Now, Dereg Whenever:
Capital Rules Debate Pits Quarles vs. Quarrels

If rapidly increasing economic growth, historic highs in financial industry profits, and capital markets in record territory of late all call for deregulation, there’s no bad time for it.  And if proponents of financial deregulation control the House, Senate, and White House — for now — this is most certainly the time, regardless of sectoral circumstances.

Here’s the story of the GOP working with financial regulators and market participants to bring down the “hairpin turn ahead” sign because no more accidents were occurring.

Best,

Dana

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Last Week, Federal Reserve Vice-Chair for Supervision Randal Quarles appeared before House and Senate Committees to answer questions on his approach to supervisory standards.  In recent weeks, the Fed has issued revisions to a number of fundamental post-crisis standards. Quarles’ innocuous words like “efficiency” and “recalibration” belie the serious systemic implications these rulemakings have.  Leading regulators at the Fed and other regulatory bodies have raised important objections.

This while a Senate Banking bill, S.2155, sits at the doorstep of the House.  The Economic Growth Regulatory Relief and Consumer Protection Act would empower the Fed to free 25 of the largest 34 banks from stress testing, living wills, and the liquidity coverage ratio.  Quarles’ rulemakings suggest he is eager to tailor the same DFA pillars that S.2155 would deregulate.

These efforts look like a solution in search of a problem. The banking sector has been unprecedentedly profitable for three years running, lending remains strong, and the economy as a whole is gaining steam.

GOP Regulatory Pref: Capital over Supervisory

Reduced capital levels run counter to what some Republican appointees and officials have suggested about the value of capital requirements. In 2016, then-Chair of the Senate Banking Committee Richard Shelby said that for years, he has “urged regulators to implement strong capital standards.”  Just a year ago, Jerome Powell suggested capital levels were just right. Now in power, conservatives seem determined to relax rules for the largest banks under the guise of “modernization,” a familiar deregulatory term.

Capital Regimes Pre- and Post-Crisis

Capital held by the five largest banks doubled from 2008 to 2015, but only from 3 percent to 6 percent. Today, equity capital requirements range from 7 percent to 11 percent of risk-weighted assets, but it appears Quarles is primed to permit a reduction in capital levels.

Proposed Revisions

• Enhanced Supplementary Leverage Ratio (ESLR) – On April 11, the Federal Reserve and the Office of the Comptroller of the Currency (OCC) issued a proposal to reduce the enhanced supplementary leverage ratio capital rules applied to Globally Systemically Important Banks (G-SIBs) and their subsidiaries. The proposal’s impact varies from bank to bank, but would slash some ESLR by up to 40 percent. Currently, G-SIBs must maintain a minimum SLR of more than 5 percent (3 percent plus a 2 percent buffer). G-SIB subsidiaries must maintain a 6 percent SLR. The new proposal would take the 2 percent buffer and turn it into a figure equal to one half of the firm’s GSIB surcharge. Subsidiaries’ SLRs would fall from 6 percent after similar tailoring.

•  The FDIC estimates this will result in the GSIB subsidiaries holding $121 billion less in capital at their FDIC-insured subsidiaries. Quarles sought to temper critics who cite this figure by predicting that aggregate capital will fall by just $400 million among bank holding companies. Nevertheless, the discrepancy here is troubling, indicating the Vice-Chair does not see systemic risk residing in subsidiaries across these firms’ operations. In the past, it was the norm for the regulatory bodies like the Fed and FDIC to be on the same page when it comes to capital requirements.

• Stress Testing/Capital Buffers – On April 10, the Federal Reserve proposed a new “stress capital buffer” that totals the amount equal to losses incurred during a hypothetical stress test or 2.5 percent, whichever is greater. The revision would replace the existing requirement that 2.5 percent of risk-weighted assets be held as capital. It also replaces the quantitative objection to a firm’s capital plans under CCAR.  Under the new proposal, if a bank has common equity tier 1 capital of 8 percent and it falls to 5 percent, the bank’s stress capital buffer would be 3 percent. This would be added to the minimum 4.5 percent common equity requirement to total 7.5 percent. Federal Reserve estimates suggest this will lead to increased capital among GSIBs, but lower levels of capital among non-GSIBs.

Some analysts are concerned, however, that the loosening of assumptions related to balance sheet growth and the time horizon for expected dividend payments, would ultimately reduce overall capital levels. Recent stress testing data projects these proposals would lower capital at major banks by $30 billion. Goldman Sachs expects the eight largest banks to reduce equity capital by $54 billion as a result of potential stress test changes.

New accounting standard for loan losses – Federal reserve rules include a new accounting standard for loan losses.  This is significant, as it requires banks to forecast and set aside money for easily foreseeable loan losses before they occur. In the lead up to the financial crisis, banks were not recognizing losses well. Since capital rules are in place to guard against unforeseen losses, combining loan loss projections (for anticipated losses) with capital requirements is potentially dangerous.

Source: Federal Reserve Bank of Atlanta; Federal Financial Institutions Examination Council; Journal of Economic Perspectives; Keefe, Bruyette & Woods; regulatory filings

Dissent

• Brainerd on Cyclicality – In the first dissent since the Federal Reserve began to publicly disclose votes, Governor Lael Brainard voted in opposition to a rule that slashes the enhanced supplementary leverage ratio. In a recent speech, Brainerd said it was too soon to consider lowering capital requirements for big banks and urged against making judgements about the current capital and liquidity coverage before a full economic cycle has been completed.

•  Gruenberg on ESLR – FDIC Chair Martin Gruenberg reaffirmed support for the SLR set in 2014, refusing to join the Fed and OCC in issuing the new proposed rule. Gruenberg said leverage ratio requirements are “among the most important post-crisis reforms,” and that “the existing simple approach has served well in addressing the excessive leverage that helped deepen the crisis.”

•  Sen. Warren – At last week’s Senate Banking Committee hearing, Sen. Warren reminded Vice Chair Quarles that taxpayers were left holding the bag when the big banks didn’t hold enough capital. Under the new rule, JP Morgan, Citigroup, and Morgan Stanley could reduce capital by more than 20 percent at their bank subsidiaries and still meet leverage capital requirements. Wells Fargo and Bank of America can each reduce their capital by more than 15 percent.

•  Wall Street Journal – Even the Wall Street Journal’s editorial board criticized the Fed’s proposed supplementary leverage ratio reduction. The board pointed out that the current 6.6 percent leverage ratio among GSIBs is only slightly greater than their losses during the stock market crash in 2008. Reducing them any further would only endanger the system, the editorial board argued.

S. 2155 in this Context

These proposals reflect Quarles’ apparent objective, to include risk-profiling in the financial regulatory capital regime.  Increased tailoring of enhanced prudential standards has been a primary post-crisis goal of congressional Republicans. Critics see tailoring as little more than a euphemism for sotto voce deregulation.

When a handful of Senate Democrats joined with Republicans to pass S. 2155, they voted to give the Federal Reserve a wide purview to tailor enhanced prudential standards on a variety of fronts for banks between $100 and $250 billion in assets.  These pillar revisions include changing the approach to company run stress tests, living wills, and liquidity requirements.

Faced with congressional questioning about how he would customize supervisory standards, Quarles highlighted four key risk profiles for supervisory standards on an individual bank– size, complexity, interconnectedness, and character of bank portfolios. In a rare case of a GOP-led Senate bill ceding authority to the Fed, S. 2155 gives the Fed sweeping discretion to tailor systemic risk rules set by DFA.

What’s Next?  Rules on Fed’s Radar

In his testimony, Quarles hinted more deregulation is on the way at the Fed.  Before the HFSC, Quarles attacked the Volcker Rule, implied he would reduce the risk-based capital surcharge at some of the nation’s largest banks, and hinted that he wanted to end limits on capital distributions due to weakness in risk management at large banks. In front of the Senate, Quarles outlined his plans improve the “regulatory efficiency” of stress testing, calibrate the LCR for non-GSIBS, and enhance stress testing transparency.

While Quarles is powering ahead, S. 2155 is currently held up in the legislative progress. The bill passed a Senate floor vote more than a month ago, 67-31, but has since been held up in the House. This is because Rep. Jeb Hensarling, the outgoing Chairman of the House Financial Services Committee, is refusing to rubber stamp the legislation. For the moment, he has the backing of House Republican leadership. Negotiating with Hensarling would surely involve making the bill more deregulatory, and that would risk alienating cosponsoring Democrats and dissolving the bill’s bipartisan backing.