BPInsights: September 23, 2023

A Comprehensive Look at ‘Optimal’ Bank Capital

The U.S. banking agencies just proposed dramatic increases in bank capital requirements. To support this significant change, the agencies stated that current U.S. capital requirements are “toward the low end of the range of optimal capital levels described in the existing literature.” This statement is frequently cited – but it is false. A new BPI note explores recent studies on “optimal” capital levels, highlighting some recently published academic papers that use modern macroeconomic models to simulate the behavior of banks, households, and businesses in response to changes in capital requirements. Such research merits thorough consideration by policymakers because it assesses changes in policy in an open and transparent manner and undergoes peer review.

The magic number: Optimal capital is a level that maximizes net public benefit – public benefit minus public costs. Current bank capital levels actually fall in the middle of the range of optimal estimates cited by the banking agencies, and are even closer to the higher end of recent academic estimates.

• A key capital ratio, the common equity tier 1 capital ratio, stood at 12.8 percent for all U.S. bank holding companies and for the largest ones, too.
• “Optimal” levels are estimated between 6-17.5 percent with a midpoint of 11.8 percent, according to estimates cited by the banking agencies.
• Recently published academic papers provide estimates ranging from 6-14.5 percent with a midpoint of 10.3 percent.

The challenges: Older estimates of optimal capital are very imprecise and vary widely depending on the underlying assumptions. One study, for example, finds that optimal capital ratio lies between 25 and 60 percent.  In contrast, more recent estimates grounded in modern macroeconomic theory comprehensively consider the effects of changes in capital requirements on decisions made by households, firms, banks and nonbanks. Furthermore, the calibration of these models is subject to a higher degree of rigor, allowing little flexibility to alter assumptions without first showing that the new calibration matches key features of the data.

Why it matters:  The banking agencies point to the academic literature on optimal capital as a key reason why they have proposed raising banks’ capital requirements.  The new requirements do not address the sources of three bank failures this spring, and the claimed need for a higher general level of capital requirements belies the fact that banks were a source of strength in the Covid crisis, have weathered the strains this spring, and pass stringent annual stress tests.  Setting capital requirements too high results in unnecessarily and permanently lower levels of output and employment, may contribute to a recession and weaken financial stability as more financial intermediation activity migrates to nonbanks.

Five Key Things

1. Basel Would Make Mortgages More Costly for Black, Hispanic and Low-Income Borrowers

Changes in the Basel capital proposal “would disproportionately disincentivize lending to [low- and moderate-income], Black, and Hispanic borrowers and communities,” according to a new report by the Urban Institute.

• CRA contradiction: These changes, such as significantly increasing capital charges for loans with high loan-to-value ratios, are “contrary to the intentions of the Community Reinvestment Act,” the report says. Regulators are working to finalize new rules for implementing the CRA.
• Who is affected? Loans with lower down payments, which have high LTV ratios, will receive the largest increase in risk weights, and the Urban Institute’s analysis demonstrates that lower-income borrowers will be disproportionately affected. The proposal would significantly raise the risk weights – the multiplier that determines how much capital banks must maintain for a certain asset based on its risk profile – for mortgages, with the highest weights for those with high LTV ratios. Low- and moderate-income, Black and Hispanic borrowers are disproportionately represented in the highest LTV loan categories. “This will translate directly into higher costs for these borrowers,” the report states.
• ‘A lot at stake’:  The implications of these changes to mortgage capital requirements are major, the report states. “There is a lot at stake here,” it says. Bank portfolios provide a niche for loans that “do not fit neatly into the credit boxes” underwritten by government-sponsored enterprises, the FHA or the Veterans Administration, the report says. The proposed capital increase will also “accelerate a broader retreat by banks from the mortgage business,” the report says.
• Key quote: “Raising the capital charges on high-LTV loans raises the mortgage interest rates for the remaining borrowers least able to afford the increases.”
• Lack of logic: “There is no logical argument for the bank capital requirements proposed in the NPR,” the report says. “They are much higher than the Basel requirements. And our analysis shows they are higher than a repeat of the 2005–08 experience would suggest is necessary to protect the financial system.”

2. Barr’s ‘Lonely’ Battle to Raise Capital Requirements

Federal Reserve Vice Chair for Supervision Michael Barr faces serious headwinds in his proposal to raise capital requirements significantly for large banks, according to a recent Bloomberg op-ed by banking columnist Paul J. Davies. Davies highlights misgivings about the Basel proposal expressed by Federal Reserve governors and by Chair Jerome Powell, and concerns about contradicting Congressional intent. The “biggest political fight is going to be over regional banks,” Davies wrote, specifically on a reversal of many facets of tailoring.

• Effects: “One big argument from opponents to US rule changes is that they will mean higher borrowing costs or less lending, or a bit of both, particularly for higher-risk mortgages and finance for smaller businesses,” Davies wrote.
• Unnecessary overlap: “[R]isks linked to trading in markets and to operational failings, such as IT malfunctions or fraud, appear to be double counted in capital and stress tests as the proposal stands,” Davies wrote. “That seems unnecessary.”

3. BPI Welcomes U.K. Attorney Samantha Riley to Regulatory Affairs Team

BPI this week announced the hiring of Samantha Riley as a Senior Vice President and Senior Associate General Counsel on the Regulatory Affairs team. Sam’s experience spans several significant policy areas in global finance. She previously served in various senior management roles at the Bank of England, including as a senior adviser to Deputy Governor Sir Jon Cunliffe. In her time at the Bank, she advised on development and coordination of international strategy, policy and regulation in a broad range of areas, including financial services, banking, digital payments, digital currencies and innovation in financial markets, and also held roles managing EU withdrawal and financial stability matters.

Before the Bank, she was assistant general counsel at the International Swaps and Derivatives Association and chaired ISDA’s Regulatory and Legal Working Group covering the post-2008 G20 reforms and developed several industry implementation projects, including resolution stay protocols for derivatives. She also previously practiced at Allen & Overy in London where she advised clients on regulatory and transactional work, covering banking, capital markets and derivatives. Most recently, Sam was a partner in Morrison Foerster’s London office, where her practice covered financial services, including financial regulation and fintech.

“Sam’s extensive experience in bank regulatory policy and range of knowledge across the global financial services ecosystem make her a formidable addition to the BPI team,” said BPI President and CEO Greg Baer. “She’s been a key voice on critical financial stability and regulatory issues in both the public and private sector. We are delighted to welcome her on board.”

4. Can Federal Agencies Sing in Harmony on Cyber Requirements?

Federal agencies should streamline their cyber incident reporting requirements by developing common definitions, timelines and triggers for industries to report breaches, according to a report by the Cyber Incident Reporting Council released this week. The report, mandated by Congress, identifies a panoply of cyber reporting requirements among federal agencies. It illustrates the range of requirements that apply to the financial services industry, as one of the nation’s critical infrastructure sectors.

• Step toward clarity: The report “highlights industry concerns with the expansion of government reporting requirements and the imperative that regulators take inventory of duplicative and conflicting requirements and establish consistent standards,” said Heather Hogsett, senior vice president of technology and risk strategy of BITS, in a Washington Post article. “Financial institutions comply with more reporting requirements than any other industry, and this thoughtful effort could help focus critical front-line resources leading to greater clarity for victim companies and better outcomes for the American financial system.”

5. Bipartisan Basel Concerns on Display at Hearing

Lawmakers of both parties raised concerns about the Basel capital proposal at a House Financial Services subcommittee hearing this week. From legal and process shortfalls to small business lending effects, members of Congress questioned the implications of the complex policy proposal.

• Explanation needed: Reps. Andy Barr (R-KY) and Bill Foster (D-IL) requested more detail on the analysis and data to support the Basel Endgame proposal in a recent letter to Vice Chair for Supervision Michael Barr. “I believe that having access to the data, and assumptions and methodology would allow for a more informed discussion across the board here,” Foster said at the hearing. The proposal “has been delivered in an underdeveloped and hurried fashion, and, in many crucial areas, is glaringly arbitrary and capricious,” Barr said in an opening statement at this week’s hearing.
• Tailoring reversal: Barr expressed dismay at the proposal’s apparent reversal of regulatory tailoring, contrary to Congressional intent.
• Small business: Rep. Joyce Beatty (D-OH) asked how the Basel proposal would affect small businesses and the cost and availability of credit. Rep. Young Kim (R-CA) also expressed this concern about small business credit and the potential for reduced lending to low- and moderate-income households. “[T]here is legitimate concern that the Basel revisions will have broad impacts on Americans’ ability to access reliable credit and increase overall borrowing costs for individuals and small businesses,” Rep. Roger Williams (R-TX) said. Rep. Scott Fitzgerald (R-WI) noted that the proposal would impose high costs on smaller and mid-sized businesses that do not have securities, such as stocks or bonds, listed on an exchange.
• Capital markets: Rep. Brad Sherman (D-CA) asked whether the proposal would discourage banks from participating in initial public offerings and in the capital markets generally. Sherman also said “raising capital standards is the bluntest way to ensure banks don’t go under. The better way to do it, is to look at the individual assets and do good bank examination. And that is where I think our regulators have failed us, because they’ve ignored interest rate risk.”
• Harmful confluence: Multiple regulatory proposals from the banking agencies, including Basel and a long-term debt proposal, could intersect in ways that harm the financial system and consumers, Rep. Barr said at the hearing. Potential consequences could affect first-time homebuyers, infrastructure financing and Treasury market liquidity, he suggested.
• M&A: Rep. Fitzgerald expressed concern that a forthcoming Department of Justice update to bank merger guidelines could depart from longstanding standards and that the capital proposal would lead to consolidation in the banking sector. He referred to policymakers “sharply increasing the regulatory burden on banks with more than 100 billion in assets, while simultaneously making mergers between those banks more difficult to close.”
• Duplicative: Rep. Kim flagged a potential double-count of operational risk in the stress test and the Basel proposal and questioned whether it was “necessary or is it duplicative? That is, could there be some double-counting going on?”

In Case You Missed It

FDIC’s Hill Raises Caution on Regulatory ‘Overreaction’

FDIC Vice Chairman Travis Hill cautioned against an overreaction from banking regulators in response to the spring bank failures. “While I think that some response to the bank failures is warranted, I worry that an overreaction is underway and that we are moving too quickly to impose a long list of new rules and expectations at a time when conditions remain precarious,” Hill said at a Cato Institute event this week. “I think any policies we adopt should be balanced, thoughtful and targeted, and that we should be mindful of both the aggregate impact of all the changes and the current economic environment.”

• Two in one: Hill said he views the Basel capital proposal as two proposals in one: one to implement the 2017 international Basel Endgame agreement, and one – “completely unrelated to the first” – to undo almost all tailoring of capital requirements. “We have already gold-plated the underlying Basel standard that exists today,” Hill said. The proposal would exacerbate that in several ways, he said. “The result will be some combination of higher prices and less availability of products and services,” he said.
• Long-term debt, resolution: Hill said he generally supports the banking agencies’ proposal to require certain banks to issue long-term debt in order to absorb losses in a failure. He expressed hope that the banking agencies would seek a consensus as they receive comments on that proposal. The FDIC’s proposed changes to banks’ resolution planning should have focused more on other aspects, such as increasing the likelihood of a weekend sale in a bank’s failure.
• M&A: Hill outlined key points on bank M&A policy, such as the high level of competition both within the banking industry and between banks and nonbanks, such as credit unions and fintechs. He also noted the broad reach of digital banking, a contrast to previous decades’ emphasis on local branches. Instead of making the merger process more difficult, policymakers should “try to address some of the underlying causes of consolidation” such as rising regulatory costs and challenges in technology upgrades. The current process is “too long and too opaque” in many cases, he said. For a struggling bank, a merger is preferable to an FDIC receivership, he said. “This feels like a bad time for a crusade against mergers,” Hill said, referring to the higher rate environment and potential credit issues.
• Liquidity: Hill called for policymakers to take a measured approach to any rethinking of liquidity rules after the spring failures. Regulators should “think holistically about reforms that reflect how banks actually behave in times of stress and are durable for the full spectrum of possible stress events,” he said. He said “perhaps the stickiest of deposits” this spring were brokered CDs, despite their reputation as “hot money.”
• Supervision: Bank supervisors should “better prioritize core safety and soundness risks,” Hill said.

Leading Financial Groups Voice Opposition to Legislation Seeking To Impose Government Price Controls On Credit Cards

In a new letter this week, eight leading financial groups representing virtually all banks and credit unions voiced their opposition to the Capping Credit Card Interest Rates Act, a misguided proposal from Senator Josh Hawley (R-Mo.) that would impose government price controls on credit cards and effectively harm the very people the legislation seeks to protect.   

As outlined in the letter, Sen. Hawley’s proposal for an “all-in” annual percentage rate (APR) cap for credit cards at 18 percent would severely restrict the availability of this type of credit for millions of consumers across this nation: 

“Including annual fees and other fees in the calculation will cause credit cards to exceed the cap, resulting in the elimination or reduction of valuable credit card features like cash back and other rewards. This cap will also impede innovative credit cards with non-credit features designed to attract underserved groups because even a nominal annual fee could result in an all-in rate that exceeds the cap.” 

To learn more, click here.

Rakuten as a Credit Union? Maybe Not

Japanese e-commerce firm Rakuten has – yet again – withdrawn its bid for a federal financial institution charter. The firm rescinded its application for a credit union charter in early September, just a few months after applying. The withdrawal marks an end to Rakuten’s fourth attempt to become a licensed financial institution in the U.S., after the firm pursued an ILC charter.

• Bottom line: The move is good news for consumers and the financial system, which may have faced risks from the commingling of banking and commerce.

The Crypto Ledger

Here’s what’s new in crypto.

• Celsius bankruptcy: In Celsius Network’s bankruptcy case, retail investors are demonstrating major influence, in contrast to typical bankruptcy proceedings, according to the Wall Street Journal.
• A family firm? Bankrupt crypto exchange FTX is suing founder Sam Bankman-Fried’s parents in order to recover allegedly misappropriated funds.
• CBDC: The House Financial Services Committee advanced a bill to block the Federal Reserve from issuing a central bank digital currency without Congressional authorization. It would also prohibit the Fed from using CBDC in monetary policy or issuing digital currencies directly to consumers. Republican opposition to CBDC has centered mostly on privacy concerns.

Trade Finance on the Blockchain: Citi Unveils Digital Asset Services for Institutional Clients

Citi this week announced the creation and piloting of Citi Token Services for cash management and trade finance. The service will integrate tokenized deposits and smart contracts into Citi’s global network, according to the bank’s announcement. The development “is part of our journey to deliver real-time, always-on, next generation transaction banking services to our institutional clients,” Shahmir Khaliq, Global Head of Services, said in a press release. “This development goes hand-in-hand with our industry leading work on the Regulated Liability Network to create interoperable digital asset solutions on a multi-bank basis.”