BPInsights: October 14, 2023

The Trillion-Dollar Omission in Vice Chair Barr’s Cost Analysis

In a speech this week, Federal Reserve Vice Chair for Supervision Michael Barr downplayed concerns about the Basel capital proposal’s effects on lending. Barr estimated that capital would increase by only 3 basis points (0.03 percent) on average for lending activities, and said that estimate accounts for both credit risk (the risk of borrowers defaulting on loans) and operational risk (the risk of large losses from unexpected events like lawsuits or cyberattacks). However, his estimate fails to account for$1 trillion in risk-weighted assets that the proposal creates to estimate operational risks associated with fee income, large portions of which are associated with various lending activities such as securitizations, credit card lending, syndicated loans, etc. Correcting that error would quadruple the effect of the Basel proposal on bank funding costs for lending business.

Digging deeper: Vice Chair Barr’s estimate comes from the banking agencies’ analysis referenced in their proposed capital rule. That analysis estimates the proposal’s effect on lending and trading activities. Based on that analysis, an approximate $780 billion increase in RWA for lending is attributed to the operational risk component associated with interest income. Additionally, there’s a $172 billion rise in RWA as a result of the trading-related portion of operational risk. Yet, the combined total of these two operational risk projections is significantly lower than the $1,950 billion in risk-weighted assets for operational risk indicated in the Basel proposal. As a result, the agencies’ economic impact analysis excludes $1 trillion in risk-weighted assets for operational risk unallocated to either lending or trading activities. We acknowledge that not all fee income is associated with lending activities for all banks. However, regardless of the proper allocation between the two categories, there is no basis for failing to allocate $1 trillion of risk-weighted assets to one or the other.

Five Key Things

1. Vice Chair Barr’s Unique View of the State of the U.S. Banking Industry

In a recent speech, Federal Reserve Vice Chair for Supervision Michael Barr dismissed any concerns that higher capital would damage the banking sector. He said bank profitability has recovered since the global financial crisis, and “as banks increased their capital cushions, their profitability grew, as did their market valuation.” This statement is false. Here’s a factual look at the state of the banking sector:

  1. The return on tangible common equity for the six largest banks averaged 23.4 percent during 2005-2006 and currently stands at 11.2 percent. For large regional banks, this figure was around 20.1 percent in the period leading up to the global financial crisis and has since decreased to 13.1 percent
  2. In price to book ratio, the industry stands below historical norms and has diverged significantly from the broader corporate sector average. In the period between 2002 and 2007, banks were trading at approximately two times their book value. Currently, they are trading at book value, which is approximately the value that investors can expect to receive in a liquidation after a bankruptcy; in other words, the market is ascribing zero franchise value to the American banking industry. 

The bigger picture: Poor bank earnings and valuations reflect business trends. For example, private capital markets have dramatically increased their market share of business debt, and banks’ role is also diminishing in mortgage lending. 

Ignoring the implications: These charts raise two important questions for debate: How large a role has more stringent bank regulation played in the significant decline in bank returns? And what are the economic growth and financial stability implications of moving a huge amount of financing away from banks to nonbanks, given the latter’s less stable funding and lighter regulation?

The Basel capital proposal, whose increased charges would tilt the market even further in nonbanks’ favor, does not consider these questions. The proposal would also reverse the tailoring of regulations for regional banks at precisely the time when the prospect of future regulation is a weight on their market valuations.

2. On Basel Proposal, Banking Agencies Owe the Public a Thorough Analysis

The Federal Reserve, FDIC and OCC must conduct a full, public study into the costs of their Basel capital proposal and re-propose the rule after the study’s results are released, the Bank Policy Institute, American Bankers Association, Financial Services Forum, Institute of International Bankers, Securities Industry and Financial Markets Association and U.S. Chamber of Commerce wrote in a letter submitted Friday. Short of a re-proposal, the agencies should extend the comment period on the proposal to 120 days after the study’s release. The significant economic impacts of the proposal, as well as legal requirements, demand a robust analysis of the proposal’s effects.

Key quote: “The banking agencies took more than five years to propose an implementation of the Basel accord, during which time they could have studied its impact on banks, their customers and the economy. Instead, regulators improperly proposed to start that process during the comment period; even then, more than 60 days into that period, they have failed to send out the required template to conduct it. Given the significant stakes for the U.S. economy, it needs to be rethought and restarted.” – BPI, ABA, FSF, IIB, SIFMA and U.S. Chamber

Background: The banking agencies proposed a rule to implement the final Basel agreement on bank capital requirements on July 27, 2023. This proposal not only overstates the risk of banks’ business lines by tacking on extraneous surcharges on top of those in the international agreement, but it also violates the law by failing to provide adequate supporting data and analysis. It is necessary for the banking agencies to undertake a quantitative impact study of the proposal; their approach to date in doing so illustrates alarming gaps, both procedural and substantive, in their rulemaking process.

Bottom line: The public has a right to know how this proposal would affect the economy before providing input on it. The proposal’s length and complexity necessitate ample time for banks, businesses and other stakeholders to understand and analyze its impact. Even if the banking agencies proceed with the required impact study, such a study would not correct numerous other flaws in the proposal.

3. WSJ: The New Kings of Wall Street Aren’t Banks

Private credit players such as Apollo, Ares and Blackstone are increasingly dominating lending, from infrastructure to real estate, the Wall Street Journal reported this week. Macro factors such as higher interest rates have accelerated the trend, but regulatory factors, such as increasing bank capital requirements, are also at play. Private credit’s growing foothold has raised red flags for some analysts, given the opacity of the market.

  •  At a glance: Private-credit assets under management globally rose to about $1.5 trillion in 2022 from $726 billion in 2018, according to the Journal. A handful of the fund managers control about $1 trillion combined.

4. Bowman: Regulatory Overhauls Can Put Financial Stability at Risk

Federal Reserve Governor Michelle Bowman highlighted several financial system vulnerabilities in a recent speech in Morocco, such as Treasury market stress, pressures from a rising-rate environment, undiversified commercial real estate portfolios and hedge fund leverage. Bowman also emphasized the need to balance regulatory and supervisory changes. Regulatory overhauls can pose risks to financial stability, Bowman said – for example, some actions can depress economic growth through reduced credit availability. “[R]egulatory reform can pose significant financial stability risks, particularly if those changes to regulation fail to take sufficient account of the incentive effects and potential consequences,” she said.

  • Targeted and efficient?: Concerns about destabilizing economic effects are “most acute when the reforms themselves may be inefficient or poorly targeted,” Bowman said. “For example, policymakers should carefully consider whether the contemplated significant increases in capital requirements in the United States related to the finalization of Basel III capital standards meet this standard for being efficient and appropriately targeted.”
  • Transparency: “As changes are made to supervisory activities, these changes should be open and transparent, and should be implemented with an appropriate consideration of the tradeoffs and unintended consequences,” Bowman said. “No regulatory or supervisory framework can be effective without accountability.”
  • Capital: Capital requirements are not a substitute for effective supervision, Bowman said. “Regulatory capital requirements, no matter how conservatively calibrated they may be, are simply no substitute for sound risk management and strong, effective, efficient, and transparent supervision,” she said. “The vast majority of improvements to supervisory functions could be accomplished without broad changes to the regulatory framework.” Policymakers should ensure that changes do not
  • Leverage ratio: Bowman emphasized the need for the U.S. to consider proposals that could strengthen Treasury market functioning and reduce the likelihood of the Federal Reserve needing to intervene in market stress. “For example, in the U.S. the largest banks are subject to a leverage ratio and global systemically important bank (G-SIB) surcharge that are set much higher than the international standard. These higher levels need to be reconsidered to ensure that dealers have adequate balance sheet capacity to intermediate Treasury markets in times of stress.”

5. FDIC Proposes Corporate Governance Guidelines for Larger FDIC-Supervised Banks

The FDIC late last week proposed new enforceable corporate governance guidelines for FDIC-supervised banks with at least $10 billion in assets or otherwise considered highly-complex. This proposal marks the first major federal banking agency action focused specifically on bank governance since Federal Reserve “board effectiveness” guidance issued a few years ago. In issuing the proposal, the FDIC noted that “strong corporate governance is the foundation for a bank’s safety and soundness” and cited poor corporate governance and risk management as a contributing factor leading to high-profile bank failures this past spring. The FDIC has issued the proposal for public comment, and voted 3-2 to approve its release.

  1. What it does: The proposed guidelines describe the general obligations of the board of directors to ensure good corporate governance and the obligations of individual directors; states that the board should establish an effective risk management program, strategic plan and a code of ethics; and state that the institution should effectively communicate its risk appetite and policies to encourage compliance by all employees and identify and report breaches of risk limits, even if the institution does not realize a loss from the breach, among other points.
  2. Dissents: The two dissents are noteworthy. FDIC board member Jonathan McKernan dissented against the proposal because it would, in his view, undermine accountability for risk ownership, conflate the roles of board and management, preempt state corporate law and potentially conflict with regulatory expectations for parent companies.
  3. Conflation of the role of the board with that of management: The guidelines stipulate that each director has a duty to “confirm” that the bank complies with all laws and regulations – a standard that far exceeds director duties under corporate law and comparable standards set by the other federal banking agencies and is inconsistent with generally understood expectations for a well-functioning board. The proposal would also require that a covered bank’s board ensure safe and sound operation of the institution.

In Case You Missed It

The Economy Has Changed. So Should the U.S. GSIB Surcharge.

In a new note by BPI, the Financial Services Forum, and SIFMA, economists explain how the U.S. methodology for assessing a capital surcharge on global systemically important banks (GSIBs) differs from international norms, overstates the risk presented by those firms, and puts them at a competitive disadvantage.  It also provides recommendations for how to rationalize the surcharge and thereby significantly expand the ability of the affected banks to expand credit availability and maintain liquidity in U.S. capital markets. Our analysis suggests that implementing these adjustments would reduce GSIB surcharges by roughly one percentage point which would expand lending and market making capacity by over $1 trillion and boost economic growth by roughly $25 billion per year without sacrificing bank safety and soundness.

  • Stepping back: The Federal Reserve said the GSIB scores would be affected unrelated to systemic risk such as general economic growth and they would periodically reevaluate the framework when they published the final rule.

BPI Webinar: Outlook for the Fed’s Balance Sheet, Money Market Conditions, Banking Conditions and Bank Regulations

BPI hosted a live webinar on Oct. 5, 2023, discussing the outlook for the Fed’s balance sheet and money market conditions, and for banking conditions and bank regulations. The discussion was organized around two panels joined by 25 additional participants featuring banking professionals, academics and researchers from the public sector. The agenda and participant list are copied here.

BPI began these roughly annual discussions, mostly on the intersection between Fed balance sheet policy and bank regulations, in February 2019, when money market conditions were beginning to show signs of reserve scarcity much earlier than anticipated, a result attributed in part to bank liquidity requirements.

Read more about the discussion here. A recording is available upon request.

Yellen: Nothing ‘Off the Table’ on Iran Sanctions Path

Treasury Secretary Janet Yellen warned that nothing is “off the table” in terms of potential sanctions against Iran in connection to this week’s Hamas attack on Israel, according to the Financial Times. Sen. Tim Scott (R-SC), ranking member of the Banking Committee, called for Yellen to testify as soon as possible about gaps in U.S. sanctions policy against Iran, including $6 billion in frozen Iranian assets recently released as part of a prisoner swap. A group of Democratic senators, including Sens. Joe Manchin (D-WV) and Jon Tester (D-MT), also called on the Biden Administration to freeze Iranian assets in the wake of the attack.

The Crypto Ledger

Hamas and other terrorist groups (Palestinian Islamic Jihad and Hezbollah) raised millions of dollars in crypto in the year leading up to this week’s attack on Israel, the Wall Street Journal reported this week. Here’s what else is new in crypto.

  • SBF on trial: FTX founder Sam Bankman-Fried’s trial continued this week, with much focus on testimony from Caroline Ellison, Bankman-Fried’s ex-girlfriend and the former CEO of Alameda Research, the crypto exchange’s trading affiliate. Ellison told the court that Bankman-Fried directed her to mislead the public and investors about ties between FTX and Alameda. (Ellison also revealed that Bankman-Fried’s disheveled hair and his low-key car, a Toyota Corolla, were part of a cultivated public image.)
  • PayPal stablecoin: PayPal’s new stablecoin so far has tepid uptake despite the hype around its release. Crypto firm BitPay, gaming firm Xsolla and travel site Xeni.com are among the early adopters of the coin, according to American Banker.

Citigroup’s Dugan: Capital Proposal Will Hurt Lending

The U.S. proposal to hike capital requirements will push lending and financial intermediation out of the banking sector, Citigroup Chairman John Dugan said in a recent Bloomberg TV interview. “We believe it really will have a material impact on the amount of lending that U.S. companies can do generally, which is not a good thing when the economy is more or less in a precarious position,” Dugan said.

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The views expressed do not necessarily reflect those of the Bank Policy Institute’s member banks, and are not intended to be, and should not be construed as, legal advice of any kind.