How Can the New Market Risk Capital Requirements Be Fixed?
The Fundamental Review of the Trading Book, the part of the Basel capital proposal aimed at market risk, would raise market risk capital requirements significantly. The large expected increase is not because banks are engaging in riskier trading, but because of overly severe and complex requirements in the FRTB.
- Differing global effects: The FRTB would disproportionately raise costs for the U.S. economy, which relies much more heavily than Europe on capital markets to finance businesses and hedge risk. Large banks operating in the U.S. also face the amplifying effect of the Fed’s stress tests, which do not take place in Europe.
- Background: The FRTB has some appealing features on principle: it measures large, rare risks more effectively than the current market risk model; explicitly accounts for differences in marketability of assets; and gives less credit for diversification of risks, addressing a potential breakdown of diversification in a crisis. But in practice, the standard is complex and overly stringent.
- Breaking it down: Because of the complexity and severity of the requirements and tests, the FRTB will raise market risk capital requirements of large banks over 60%, and the capital requirements of the largest banks, mostly financial institutions in the U.S., by almost 70%. These increases do not correspond to an increase in underlying trading risks.
- How to fix it: To avoid damaging the U.S. economy, the Fed should update its stress tests to reflect the changes in the risk weighted assets framework by removing private equity from the global market shock and by ensuring those shocks also address different risks than the FRTB. In addition, it should also fix the FRTB in a pragmatic way before the U.S. implements Basel III Endgame. For example, U.S. regulators could allow banks more flexibility to satisfy the stringent statistical tests in the FRTB without rolling over to punitive standardized formulas. Regulators could also modify FRTB formulas with arbitrary parameters – for example, they could acknowledge the benefits of diversification between assets like foreign-exchange rates that would likely maintain some diversification benefits in a financial crisis.
- Big picture: When taken too far, increasing market risk capital requirements will make the U.S. financial system less safe – banks can create a natural hedge during market volatility by generating additional revenues from trading, and capital requirements that make trading activity more costly may reduce this buffer effect. Unjustified increases in market risk capital can also damage market liquidity. An overly severe, complex FRTB could increase risks among banks by discouraging them from having trading businesses.
Five Key Things
1. Fed IG Report: Supervisors Missed SVB Red Flags
Federal Reserve supervisors failed to effectively oversee Silicon Valley Bank as it rapidly grew and as interest-rate risk loomed over its portfolio, the Federal Reserve Board’s Inspector General said in a report this week. The report strikes contrasts to the April postmortem on SVB’s supervision and regulation led by Vice Chair for Supervision Michael Barr, which placed emphasis on an allegedly lax supervision culture under Barr’s predecessor. The OIG report resulted in three findings and seven recommendations to improve supervision going forward.
- Specific lapses: SVB’s supervisors at the San Francisco Fed and the Federal Reserve Board of Governors identified risks to the condition of the bank, but failed to escalate them in a timely and effective manner, the report said. The Regional Banking Organization (RBO) supervisory approach for SVB did not evolve as the bank grew rapidly larger and more complex; the Board and the San Francisco Fed failed to effectively transition the bank from the RBO portfolio to the Large and Foreign Banking Organization (LFBO) supervisory program once it exceeded $100 billion in assets; and examiners should have more closely scrutinized the risks posed to SVB’s “held-to-maturity” bond portfolio by rising interest rates, according to the IG report. SVB’s examiners focused too much on risk management processes rather than financial condition, the report said.
- Recommendations: The report recommended several steps to remedy these problems, such as evaluating the RBO framework to determine whether changes are needed, and tailoring large bank supervisory plans included under the LFBO framework to “better promote a timely focus on salient risks.”
2. UK Delaying Basel Implementation
The Bank of England will delay implementing the latest Basel capital rules for another six months, aligning the UK’s timeline with the U.S. The new implementation deadline will be July 2025, delayed from January 2025, according to the Financial Times this week. The Bank of England plans to shorten the five-year phase-in period for the measures by six months, according to the article.
3. Leading Financial Groups Voice Opposition to Legislation Seeking to Impose a National Fee and Interest Cap on Consumer Loans
In a letter sent this week, seven leading financial groups representing virtually all banks voiced their opposition to a proposal from Senator Jack Reed (D-R.I.) that would reduce access to credit within the well-regulated banking system through the imposition of a national fee and interest rate cap of 36 percent.
As outlined in the letter, Sen. Reed’s proposal would actually harm consumers who want to obtain credit: “Small dollar loans, credit cards, and other forms of short-term credit are critical for helping consumers meet emergency expenses, disruptions in pay, and misalignments in the timing of their expenses and income. The proposed 36 percent fee and interest cap would make it more difficult for many consumers to obtain credit, thereby harming the very consumers the legislation seeks to protect.”
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4. Is there a Ticking Time Bomb in the Treasury Market?
Hedge funds have amassed huge leveraged positions in the Treasury market as part of so-called basis trades that seek to profit from differences between cash and futures prices for Treasuries. Hedge funds are filling a void left by banks, which are discouraged from entering into such trades by certain banking regulations, notably leverage requirements. These trades expose the firms that engage in them to liquidity pressures from repo market disruptions or increases in margin requirements for futures contracts. And hedge funds, unlike banks, do not have direct access to Federal Reserve liquidity facilities. The potential for liquidity pressures on hedge funds to create volatility in the treasury market, which is the world’s most crucial bond market, has drawn recent scrutiny from the Bank for International Settlements and the Federal Reserve, according to a recent Financial Times article. The March 2020 pandemic market seizure and the flare-up in the UK bond market last year serve as warning signs of what could happen in a liquidity meltdown.
- Moral hazard: The FT article discusses concerns about moral hazard in the Treasury market, centered on assumptions that the Fed would have to intervene in a liquidity crisis. This topic was the subject of a 2021 BPI post, which states: “[P]rivate sector markets are becoming accustomed to central bank support; those markets are likely growing inorganically large on the assumption of that support; private sector market making continues to be discouraged by regulation; and thus the need for future central bank support continues to grow. If for any reason that support were ever withheld, the results would be devastating. And, so, on our present course, it never will be withheld.”
5. House Bill Levels the Playing Field for Digital Asset Custody
BPI expressed support this week in a letter for legislation introduced by Reps. Mike Flood (R-NE) and Ritchie Torres (D-NY) to enable consistent treatment across banks and nonbanks for digital asset custody. The bill would address consequences of the SEC’s Staff Accounting Bulletin 121, which has made it economically prohibitive for banks to hold digital assets in custody for clients by requiring them to hold these assets on their balance sheets. Nonbanks, meanwhile, do not face the same prudential requirements as banks, and are therefore not precluded from engaging in such services. “The legislation would rightfully prohibit the banking agencies and the SEC from requiring regulated banks to include assets held in custody as a liability or to hold additional regulatory capital against those assets, allowing regulated banks to more fully engage in custodying crypto assets,” BPI President and CEO Greg Baer said in a statement. “Congress has a critical role to play in the oversight of the emerging digital and crypto assets market and related fintech innovations, and we appreciate Representatives Flood and Torres’s leadership on this issue.”
In Case You Missed It
Bank of England Eyes Strengthening Nonbank Financial Firms
In a recent speech, senior Bank of England official Andrew Hauser highlighted the UK central bank’s forthcoming efforts to enhance stability among nonbank financial intermediaries. Recent events such as the 2020 “dash for cash” market stress and a meltdown among UK liability-driven investment funds have raised alarms about nonbank fragility, according to the speech. The speech focused on the necessity of central bank lending to nonbank financial firms under stress; the design of such a central bank lending facility; and how to tackle the practical and operational challenges of such a tool. The forthcoming tool will enable the BoE to lend to nonbank financials, starting with insurance-company and pension funds, which were at the center of last year’s gilt market stress.
- Key quote: “The impetus for this work is real and pressing: [nonbank financial institutions] have introduced important new sources of systemic risk, and our current toolkit – though effective – is incomplete, with bank lending tools unable always to reach the source of the problem, and asset buy/sell tools posing financial and policy risks,” said Hauser, the Bank’s executive director for markets. “But to reach our goal we must solve a series of daunting policy and operational questions. We have much to learn as we embark on this journey.”
- FSB: Meanwhile, the Financial Stability Board is also scrutinizing nonbanks by kicking off a review into debt held by firms outside the banking system, including hedge funds and private capital, citing concerns about financial stability threats. The review aims to reduce risks by increasing transparency and potentially imposing limits on leverage taken by nonbanks.
The Crypto Ledger
After FTX collapsed, Binance became a dominant player in the crypto universe, but now the exchange is foundering amid heightened regulatory scrutiny, the Wall Street Journal reported this week. Here’s what else is new in crypto.
- Crypto without borders? Binance has begun the process of selling its business unit in Russia, and a press release announcing that decision says the firm will focus on “the 100+ other countries in which we operate.” But the exchange’s website’s “countries and regions” page only lists 45 countries, according to Protos. The list includes countries where the exchange has come under scrutiny, including France.
- SBF latest: FTX founder Sam Bankman-Fried will soon stand trial on fraud charges, and a judge recently denied his request to be released from jail during that time. (There is some good news for the disgraced founder: He will be able to wear a suit in court.)
- Crypto scam, bank failure: The demise of a tiny bank in Elkhart, Kansas appears to have begun with a crypto scam, Bloomberg reported this week.
TD Bank Pledges $5M to Campaign Supporting Indigenous People
TD Bank this week announced it has pledged $5 million over five years to the Future Generations Foundation’s Beyond Reconciliation Campaign. The gift comes as part of TD’s TD Ready Commitment, a global corporate citizenship platform. The Canada-wide campaign focuses on bridging the gaps left by Indigenous residential schools in Canada.