Banking regulations need to be appropriately calibrated for different types of banks. Observers generally agree that the applicability and stringency of prudential banking regulations should vary according to factors such as the size, complexity, organizational structure and business model of banking organizations. Accordingly, over time, several banking regulations have set fixed nominal thresholds to determine the scope and stringency of their requirements. For example, a regulatory threshold might be based on the size of a bank’s total exposures.
However, even if fixed thresholds are well developed and empirically supportable at the outset, when they are not indexed or adjusted to reflect general economic growth and inflation, they can become outdated. A bank’s total exposures might grow larger simply because the whole economy is growing, not because the bank’s portfolio is becoming riskier or more complex. But if the thresholds do not change, this normal growth could suddenly subject the bank to much stricter rules. This would be counter to the original purpose of having different requirements for banks of various sizes.
Some regulations recognize this issue and require regulators to regularly review and update their thresholds. Other regulations do not explicitly require updates but suggest that regulators should reconsider the thresholds when necessary. Unfortunately, in many cases, these adjustments have not been made. This has become a significant issue, especially considering how much the financial system has expanded since the COVID-19 pandemic began in 2020.
Without such updates to these regulatory thresholds, there is a risk of imposing unnecessarily strict regulations on banks that haven’t actually become riskier, which could have negative effects on the broader economy.
One example is the global systemically important bank (GSIB) capital surcharge imposed on the largest banks. Solely as a result of economic growth and inflation, capital requirements on the largest banks have increased 10 basis points each year on average under the GSIB surcharge framework.[1] Similarly, regulators rely on nominal thresholds for certain risk-based indicators to determine how prudential regulations are tailored for banks of different sizes. Unlike the capital surcharge, these thresholds were set without any explicit calibration in the first place, which further strengthens the reason to address this concern.
Economic growth and inflation do not increase systemic risk in the financial system. As the economy expands, various sectors of the economy grow proportionally. First, rising household incomes improve consumer creditworthiness, enabling larger loans supported by improved ability to repay. Second, economic expansion leads to the creation of new businesses and the expansion of existing firms to meet this growing demand. These firms, ranging from small firms to large corporations, use bank loans and financial services to support their operations. In addition, the rising costs of consumer goods and housing prices due to inflation further increase borrowing levels.
The Federal Reserve’s GSIB methodology has not been updated since its inception in 2015. Given the relationship between economic growth and the size of the banking sector, the Fed should introduce automatic adjustments to fixed nominal thresholds based on indexing to economic growth, like nominal GDP. This post focuses specifically on how the Federal Reserve could automatically adjust the thresholds that determine bank category tailoring as well as the coefficients of the GSIB surcharge for economic growth.[2]
Tailoring Category Thresholds
In 2019, the U.S. regulatory agencies finalized the tailoring rule to revise the criteria for applicability of a range of prudential regulatory requirements for large banks. This rule established a framework that imposes increasingly stringent standards to banks based on their size, complexity and risk profile.
The most stringent capital and liquidity requirements apply to Category I firms, identified as U.S. GSIBs. The next most stringent standards apply to Category II firms, with more than $700 billion in total consolidated assets, or cross-jurisdictional activity of $75 billion or more. Category III firms are those with more than $250 billion in total consolidated assets or $75 billion or more in either STWF, Non-Bank Assets, or Off-Balance-Sheet Exposure. The Federal Reserve Board determined all these indicator thresholds except the $250-billion Category III threshold, which was statutorily defined by the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA), passed by Congress in 2018.
In the final rule, the agencies did not present empirical support for their threshold calibrations. However, responding to commenter concerns, the agencies did commit to periodic threshold reviews to account for economic growth and inflation. This commitment acknowledges the need for regulatory frameworks to evolve with the economy, to maintain effectiveness and avoid unintended consequences.
Since the end of 2019, nominal GDP has grown by 34 percent. If thresholds were adjusted proportionally to this economic growth and inflation proxy, the Category II size threshold would increase from $700 billion to about $950 billion, and the Federal Reserve Board calibrated risk thresholds across categories would increase from $75 billion to about $100 billion.[3]
These adjustments would not compromise financial stability. Instead, they would ensure the regulatory framework remains aligned with the current economic reality, preserving the framework’s effectiveness while preventing potential distortions in the banking sector. Periodic review and adjustment of these thresholds, as initially intended by the regulatory agencies, would foster a more dynamic and responsive regulatory environment. This approach would balance prudential oversight with the need for a competitive, efficient banking system.
GSIB Surcharge
The Federal Reserve uses a framework known as Method 2 to assign risk-based capital surcharges for U.S. GSIBs. This framework assesses a bank holding company’s systemic risk profile using five broad categories: (1) total exposures of the bank (size), (2) interconnectedness with other financial institutions, (3) involvement in complex financial products, (4) the bank’s global footprint and cross-border claims and liabilities and (5) reliance on short-term wholesale funding (STWF). Moreover, three of these five categories have several systemic indicators necessary to calculate the overall score. The Method 2 score includes a total of 10 systemic indicators, of which nine need to be recalibrated periodically to account for economic growth.[4]
The GSIB score, used to determine the capital surcharge on the largest banks, is calculated by multiplying each of the 10 systemic indicators by a coefficient. In principle, these coefficients are designed so that each of the five broad categories contributes exactly 20 percent to the overall score.
GSIB Coefficient Mechanics
The rule quantifies an individual bank’s systemic risk using 10 systemic indicators distributed across the five broad categories we described. Each of the 10 indicators is converted to “points” by taking each bank’s indicator multiplied by a “coefficient,” which represents a proxy of each bank’s market share for that metric. The U.S. GSIB surcharge rule was made more stringent than the Basel rule by doubling each of the coefficients attached to each systemic indicator (and by replacing substitutability with STWF).
For example, if the aggregated “size” of the global banking system is about $90 trillion, and Bank “A” has $1 trillion in assets, it comprises about 111 basis points of the total market, or 111 points. If the weighting for the size component is 20 percent and the coefficient is doubled, then the result is 44 points.[5]
A sample calculation ($ in billions) for Bank “A” would be:
The Federal Reserve measures the GSIB surcharge annually, but the Fed intentionally left the coefficients “fixed” at their original 2015 calibration. Although the final rule acknowledged the need for periodic adjustments to account for economic growth within the system, no adjustments have yet been made, even as we approach the 10-year anniversary of the original rule. For context, U.S. nominal GDP has grown by 55 percent since 2015.
Table 1 shows how the Federal Reserve could make the needed adjustments to the GSIB surcharge coefficients to account for economic growth and inflation. The first column reports the current coefficient attached to each systemic indicator across the five broad categories of Method 2. The second column shows the economic growth adjustment deflator of 1.55x, which represents an adjustment for the estimated 55-percent U.S. nominal GDP growth since the original calibration. The third column displays the coefficients after applying the economic growth adjustment. Note that the coefficient for STWF remains unchanged.
Table 2 presents the adjusted scores and surcharges. The actual change in the GSIB surcharge for economic growth and inflation depends on bank business models, with the universal banks receiving larger changes, since the STWF accounts for a smaller share of their overall score. As a result, the Federal Reserve should also revert the weight of the STWF component to 20 percent.[6]
Summary
The periodic adjustment of regulatory thresholds to account for economic growth and inflation is crucial for maintaining an effective, balanced financial regulatory framework. As demonstrated in this analysis, both the tailoring category thresholds and the GSIB surcharge coefficients would benefit from such adjustments.
Adjusting the tailoring category thresholds for banks based on economic growth and inflation would prevent banks from facing more stringent regulations solely due to natural economic expansion. This consideration is particularly relevant, given the significant economic growth and inflationary trends since the onset of the COVID-19 pandemic.
Likewise, updating the GSIB surcharge coefficients to align with nominal GDP growth since 2015 would ensure that surcharges remain proportional to the actual systemic risk posed by these institutions relative to the economy’s size. This approach prevents unintended increases in capital requirements that could potentially impede economic growth without offering corresponding benefits to financial stability.
[1] In this blog post, we estimate a 70-basis-point increase in the GSIB surcharge for economic growth since 2015.
[2] The $100-billion and $250-billion size thresholds prescribed in the Dodd-Frank Act are fixed by statute so this post will not focus on them.
[3] Adjusting the thresholds for Category II is particularly important, because Category II is intended to be reserved for the largest and most complex non-GSIBs. An overly inclusive Category II threshold would undermine the category’s utility and overstate the systemic importance of non-complex banks. For example, with respect to cross-jurisdictional activity, as the Federal Reserve has previously observed,
[F]oreign exposures may . . . arise from business activities that are not as complex. For example, a firm may offer a simple, non-complex product such as consumer credit in multiple jurisdictions or have foreign exposures as a natural extension of its U.S.-based business that do not make the firm more complex or risky. As a result, a metric aimed at accounting for complexity that is based solely on the size of a firm’s foreign exposures, in this context, may be over-inclusive.
See 82 Fed. Reg. 9308, 9312 (February 3, 2017).
[4] As we discuss, the short-term wholesale funding (STWF) systemic indicator is already implicitly adjusted for economic growth.
[5] The doubling offers a better statistical fitting for the distribution of the capital surcharge assessment across banks.
[6] The STWF score is measured relative to each bank’s average risk-weighted assets; therefore, economic growth is appropriately reflected in the numerator and the denominator of the ratio. However, the Federal Reserve should also recalibrate the STWF coefficient of 350 to restore the weight of this component to its original 20 percent.
[7] For example, see “The Federal Reserve Should Revise the U.S. GSIB Surcharge Methodology to Reflect Real Risks and Support the Economy” (October 11, 2023), available at https://bpi.com/the-federal-reserve-should-revise-the-u-s-gsib-surcharge-methodology-to-reflect-real-risks-and-support-the-economy/
