What Is Next for Capital Regulation? Hard Choices About Dynamism and Procyclicality
What Is Next for Capital Regulation? Hard Choices About Dynamism and Procyclicality

On June 25, the Federal Reserve announced the results of its annual stress test, supplemented by an ad hoc sensitivity analysis that was run in parallel. These results were accompanied by a requirement for firms to update their capital plans and the announcement of two new rules for the third quarter 2020 capital distributions — share repurchases are prohibited, and common dividends may not increase from second-quarter levels and are capped at an amount equal to the average of the bank’s past four quarters of earnings.

This note analyzes the policy rationales for the Federal Reserve’s new sensitivity analysis and capital distribution rules, including how they fit within the existing regulatory regime. The note describes an unavoidable tension between dynamism and procyclicality in capital requirements and concludes that the Federal Reserve should commit to implementing the stress capital buffer (SCB) to govern capital distributions for the fourth quarter. If the Fed should decide that a further degradation in economic conditions warrants another sensitivity analysis — whether as an examination tool, a public disclosure tool or as the basis for share repurchases or dividend limits or a retooled SCB — it should be clear about its purpose, and revisit all the assumptions of the analysis to conform to that purpose. …


Image for post
Image for post

We are at an interesting time in bank capital regulation. U.S. banks have performed very well thus far, but the current economic outlook is worse than the severely adverse scenario assumed in the ongoing stress test, and an even deeper and longer recession than currently projected is possible. Thus, the question has arisen how regulators should account for these developments.

In its supervision report, issued May 8, the Federal Reserve stated that “the current plan is to conduct the 2020 supervisory stress test as originally announced — to maintain the established process under the Federal Reserve’s stress test and capital rules — and also conduct a series of sensitivity analyses using alternative scenarios and certain adjustments to portfolios to credibly reflect current economic and banking conditions.”[1] In a parallel statement made a few weeks earlier, Vice Chair Quarles said on April 10, “I think the right thing to do is for us to continue our stress tests, but as part of them to analyze how banks’ portfolios are responding to real, current events, not just to the hypothetical event that we announced earlier this year.”[2]


Image for post
Image for post

The Federal Reserve has stated that as part of this year’s Comprehensive Capital Analysis and Review (CCAR) stress test, it will “conduct a series of sensitivity analyses using alternative scenarios and certain adjustments to portfolios to credibly reflect current economic and banking conditions.”[1] While speculation on how it might do so has focused on credit risk — for example, what alternative unemployment and GDP assumptions it might use — a look at operational risk would seem equally warranted if the goal is to credibly reflect banking conditions.

While operational risk is rarely discussed as a key component of the CCAR stress test, it actually plays a substantial role and is a major driver of stress-based capital requirements. For 2019, the Federal Reserve reported that it presumed $123 billion in operational losses across the 18 participating banks.[2] So it is a number worth analyzing as part of any sensitivity analysis. …


Image for post
Image for post

Economic turmoil related to the Covid-19 pandemic has spurred calls for the Federal Reserve to prevent US banks from issuing dividends, following similar moves by regulators in Europe and the UK. Such action would produce little to no benefits and substantial costs. In fact, a ban could strain banks’ ability to support lending and economic growth, both now and over the long term.

Thus far, US banks have been able to meet much of the unexpected demand for capital and liquidity created by this abrupt decline in economic activity. US banks dramatically expanded their lending at the onset of the health and economic crisis. …


Reserve Requirements Should — and Must — Be Set to Zero
Reserve Requirements Should — and Must — Be Set to Zero

Section 19 of the Federal Reserve Act authorizes the Federal Reserve Board to establish reserve requirements on depository institutions “…solely for the purpose of implementing monetary policy….” Confirming the implications of that limitation, the Act specifically states that reserves requirements “may be zero.” Consistent with this statutory limitation, the Federal Reserve Board’s Regulation D states that the purpose of reserve requirements is “…facilitating the implementation of monetary policy…”

As of January 2019, the Federal Open Market Committee (FOMC) decided that it would henceforth conduct monetary policy using an “abundant reserve” or “floor” implementation framework. The first Fed staff study considering a floor framework states, “This option would reduce reserve requirements to zero…” This expectation is completely reasonable. Under the Federal Reserve’s earlier approach to monetary policy (a so-called “corridor system”), reserve requirements supported the implementation of monetary policy by helping to create a stable demand for reserves. In the floor framework the Fed has now adopted, the Fed oversupplies reserve balances, driving the federal funds rate down to the “floor” established by the interest rate the Fed pays on reserves; so using reserve requirements to establish a stable demand for reserves is unnecessary. …


Federal Reserve Vice Chair for Supervision Randal Quarles
Federal Reserve Vice Chair for Supervision Randal Quarles

Last Thursday, Vice Chair Quarles delivered a speech titled The Economic Outlook, Monetary Policy and the Demand for Reserves. While the title was not evocative, it was an important and interesting address on a variety of fronts. Its central focus was the role that the Federal Reserve’s supervisory regime has played in recent repo market upset, but it also had major ramifications for the size of the Fed’s balance sheet and how it views the role of the discount window. Set forth below are some of the major takeaways.

First, the Vice Chair clearly acknowledged that banking supervision (including both the traditional examination process and resolution planning) was having a significant effect on the repo market and monetary policy implementation. Post-crisis, regulators generally have been reluctant to study or acknowledge costs that come with heightened regulation, and this marks a significant exception. He and others at the Federal Reserve have closely studied the causes of recent repo market behavior, and the speech included a forthright discussion of some of the results of that study. …


Federal Reserve
Federal Reserve

During the financial crisis, the Federal Reserve and other government agencies took extraordinary actions to support the financial sector. Those actions were an appropriate response to unprecedented events, but vastly increased government’s role in financial markets. Ten years post-crisis, however, the Federal Reserve’s role in financial markets has not returned to its pre-crisis norm and only continues to grow.

The Fed’s expanding role owes much to interactions between its regulatory and monetary policies. Several post-crisis regulations and examination mandates encourage banks to prefer the Fed (or other government entities) as counterparties rather than other banks or financial institutions, and more generally to retreat from financial market intermediation critical for monetary transmission. …


Reputation Survey
Reputation Survey

Every once in a while, one comes upon a piece of research that is truly eye opening, and such is the case with an article by Professor Julie Anderson Hill, Regulating Bank Reputation Risk.[1]

For some time, I have expressed concerns about how the concept of reputational risk has allowed the examination process to proscribe bank activities that are both legal and raise no material safety and soundness risk — in effect, shifting the role of examination from protecting depositors (and ultimately the Deposit Insurance Fund and taxpayers) to protecting shareholders — examination as management consulting.[2] Or political consulting — as the use of reputational risk also has the potential to politicize examination. Once the two guardrails of legality and materiality are removed, there is little to constrain the scope of examination mandates that can occur. …


One Hand Clapping: Why the Fed Must Act for Mortgage Reform to Succeed
One Hand Clapping: Why the Fed Must Act for Mortgage Reform to Succeed

Written by Greg Baer and Francisco Covas — August 29, 2019

Any time now, the Administration is expected to present its plan for reform of Fannie Mae and Freddie Mac. And by all accounts, one goal of that plan will be to shrink the footprint of the government-sponsored enterprises (GSEs) and the predominant role those two firms currently play in mortgage finance. That goal faces a potential roadblock, however. If the share of the mortgage market held by the GSEs is to shrink, either the mortgage market must also shrink by a corresponding amount — an outcome no one wants — or the private sector, and banks in particular, must fill the void. …


Image for post
Image for post

Written by Greg Baer and Naeha Prakash — March 14, 2019

Machine learning has the potential to democratize access to credit. It can expand the pool of people qualified to obtain credit — most notably low- and moderate-income (LMI) borrowers — and decrease the cost of that credit. It also can increase access to credit and reduce systemic risk by allowing different banks to analyze different factors, and thereby generate different results in a way that the existing, FICO-based system discourages. The greatest current obstacle to this development is pressure from the banking regulators to continue adhering to the status quo system, lest machine learning produce an unfortunate outcome. …

About

Greg Baer

Greg Baer is the President & Chief Executive Officer at the Bank Policy Institute. www.bpi.com/person/greg-baer

Get the Medium app

A button that says 'Download on the App Store', and if clicked it will lead you to the iOS App store
A button that says 'Get it on, Google Play', and if clicked it will lead you to the Google Play store