About that Deregulatory Wave…

As planning for the presidential transition proceeds, there are some voices calling for a rollback of what they describe as the reckless bank deregulation of the past few years.  Their rhetoric echoes that of 2009, but the reality of 2020 is very different.

As the Financial Stability Board recently explained, “In contrast to the 2008 financial crisis, the shock originated outside the financial system,” and “banks and financial market infrastructures, were able to absorb rather than amplify the macroeconomic shock.”  Nowhere was that more true than in the United States, where banks lent over $600 billion in the first month of the crisis (compared to $130 billion by the Federal Reserve).  At no point was the health of the banking system questioned by markets or policymakers.  “The pandemic stressed the resilience of banks, but they remain well capitalized,” the Federal Reserve said in its recent Financial Stability Report. 

How did this happen?  Significant changes to the financial regulatory regime were made through the Dodd-Frank Act in 2010 and initiatives to significantly tighten capital and liquidity regulation through the Basel regulatory process.  Some of those changes were revisited over the past few years, but the changes were modest and have now proven benign.

Regulatory tailoring was the product of bipartisan legislation in 2018 and effectively mandated that a regional bank that focused on commercial banking should be regulated and examined differently from a universal bank that operated globally and engaged in major securities activities. The same was true for foreign banks that basically operated regional banks in the United States.  All of these firms have supported the economy this year without any questioning of their resilience.  And foreign banks continue to shrink their presence in the United States – with one major firm recently announcing a sale of all its U.S. assets and another announcing a pivot towards Asia.  Most would say that is probably not good news, but it certainly is no evidence of those banks capitalizing on a U.S. deregulatory wave.

Banks proved themselves not only financially resilient but operationally resilient as well.  Ahead of a planned new wave of resilience regulation, America’s banks managed to continue serving their customers (with critical forbearance and accommodation programs for COVID-impacted consumers) and administer the PPP program seamlessly, even as they moved their workforces to home work.  

The regulations with the greatest impact on the banking business are capital and liquidity requirements.  After more than doubling their capital levels and more than tripling the amount of cash or cash equivalents they held, the largest banks on Jan. 31, 2017 held $1.25 trillion in common equity tier 1 capital and $3 trillion in high-quality liquid assets (HQLA). As of June 30, 2020, capital was increasedto $1.3 trillion and HQLA jumped 50 percent to $4.5 trillion.   For the very largest banks, a GSIB surcharge is a significant tax on their capital markets activities; that tax has steadily increased as the Fed has failed to follow through on its 2015 commitment to index it for economic growth.  

The Federal Reserve has simplified the capital framework by reducing the number of capital requirements from 13 to eight earlier this year.  The simplification involved combining stress test results with static, Basel III requirements.  While the change dropped the leverage hurdle from the stress test, it also had the effect of adding GSIB surcharges to the risk-based hurdle. Fed analysis showed that the net change resulted in an increase, not a decrease, in capital requirements. There have also been modest increases to the transparency of the stress testing regime, but they have been so minimal that they shed essentially no new light on the Fed’s stress testing models. 

So, leaving aside this multi-year trend, what of the crisis response?  Unlike EU and UK regulators, the Federal Reserve took no action to lower risk-based capital requirements. Furthermore, even for banks in full compliance with all applicable capital standards, it has barred share repurchases and dividend increases, and restricted existing dividends.  It did so even after running a special stress test that demonstrated that even with a second onset of COVID-19 and a resultant economic downturn (the “W” scenario), the great majority of large banks still had ample capital.  Thus, since March, every major bank has increasedits risk-based capital ratios. According to the Fed’s Supervision and Regulation Report, the average risk-based capital ratio for a sample of large banks at the end of 2019 was 11.6 percent; at the end of the third quarter it was 12.1 percent. While the post-crisis capital regime was designed to be countercyclical, with banks reducing their capital and liquidity buffers to support economic activity, that simply has not happened.

The one major accommodation the Fed has made for large banks is to deduct deposits at the Fed (reserve balances) and U.S. Treasuries from their leverage ratios for regulatory capital purposes.  Reserve balances are the lowest risk (zero) most liquid (immediate) assets imaginable.  The deduction became necessary when the Fed, wearing its monetary policy hat, increased reserves by $1.2 trillion since March of this year.  Since banks as a whole have to hold these reserves, the alternatives to the exclusion were raising capital to support the risk of holding cash (?!) or shrinking their other assets – namely loans – to maintain compliance with leverage ratio requirements.  Like every other major regulator in the world, the Fed concluded that was nuts.

The story on liquidity is much the same.  There has been no regulatory relief – before or during the current crisis.   As of the last quarter, the largest banks were holding a remarkable23 percent of their assets in HQLA.  Moreover, the U.S. regulators in October imposed yet another liquidity requirement on the largest U.S. banks, the Net Stable Funding Ratio, which requires banks to hold more stable funding to support longer-term assets. This was not a deregulatory action.

But they’re making up for all these headwinds by proprietary trading, after repeal of the Volcker Rule!  Well, no. The Volcker Rule is still in place; the only difference is that regulators have changed the compliance regime from a “pre-crime” approach where banks were required to prove on a daily basis that they were notprop trading to an approach where they are examined for compliance and punished for any violations – the same approach applied to every other law.  Bottom line: despite some confident predictions to the contrary, there has not been a single accusation of proprietary trading made against any bank over the past three years – or the seven years before that.  Indeed, the greatest regulatory concern raised by the events of March 2020 is that banks are discouraged by regulation not only from proprietary trading but also from traditional market making.

Lastly, the current crisis confirmed yet again that the largest banks are no longer viewed by financial markets as too big to fail. Pricing on their bonds and bond insurance rose along with market uncertainty in the same way as other banks and non-banks.  Previous research had shown no market boost in stable economic conditions; the same proved true under stress.

Meanwhile, on the examination and enforcement side, the banking agencies have continued to grow their examination staffs, and 2020 was a year of record fines for the banking industry.So those touting this rhetoric are fighting the last war.  Smart policymakers will be asking themselves why the Fed had to intervene to backstop every fixed income market in the country – from Treasuries to corporate debt to municipal securities – what the moral hazard consequences of that intervention have been, and how we can create a market that does not require a recurrence.  Furthermore, capital and liquidity buffers that banks have been holding across economic cycles are not serving their intended purpose, and thus appear to be a drag on economic growth without a corresponding benefit.  If greater economic growth is desired as we emerge from the pandemic, that would be a great place to start.