Each bank in the United States designated by the Financial Stability Board and Basel Committee on Banking Supervision as a global systemically important bank (GSIB) is held to a capital standard that is higher than that required of other banks by an amount equal to its “GSIB surcharge.” This surcharge was finalized in a rulemaking by the Federal Reserve Board in 2015. The eight U.S. GSIBs make essential contributions to the economy – they make 45 percent of bank loans to businesses and households, support roughly three-quarters of the credit intermediation in capital markets, and provide nearly all the credit needed for international trade. The GSIB surcharges, which range from 1.5 to 3.5 percentage points, make these institutions more resilient to losses. But because capital is an expensive source of funding, they can also reduce the supply, or increase the cost, of credit to the U.S. economy, so getting their level right is important.
As discussed in a Fed whitepaper accompanying the final rule, in calibrating the GSIB surcharge in the United States, regulators sought to ensure that the “expected social impact” of a GSIB failure was no higher than the expected social impact of the failure of a not-quite-GSIB. “Expected social impact” is defined as the probability of failure times the social cost of failure, which is akin to the economy-wide output and employment losses that result from the GSIB’s failure. Consequently, the calibration critically depends on two things: 1) the relationship between bank characteristics – such as measures of size and interconnectedness – and the social cost of failure; and 2) the relationship between capital and probability of failure.
There are five important questions we think Fed policymakers should be asking staff about the method that was used to determine a bank’s surcharge. We have provided some initial observations that are worth exploring while trying to reach the answer to the questions posed below.
Question 1: On what empirical basis did the Board pick the bank characteristics that determine a bank’s social cost of failure? What other configurations were considered and why were they rejected?
The characteristics were picked using a method one senior member of the Fed’s official staff described as “…best interpreted as a judgment by bank supervisors…” Passmore and Haften (2017), p.9. Using a standard market-based measure of systemic importance as a proxy for social cost of failure, Covas (2017) finds that not all of the current set of characteristics are statistically and economically important.
Question 2: How much have improvements since 2015 – such as 1) the progress on living wills, 2) the elimination of derivative cross default clauses, 3) the addition of loss-absorbing, long-term debt that reduces risk-taking behavior and can provide new capital in the event of failure, and 4) the stockpiling of liquid assets that make fire sales of illiquid assets much less likely to occur – reduced the systemic costs of resolving a GSIB and the probability of failure of a GSIB?
Joint BPI/FSF analysis cites research from the Financial Stability Board indicating that the reduced social costs of failure and the lower probability of default from just the additional long-term debt and liquidity warrant reducing GSIB surcharges by about 1½ percentage points. It is also worth noting that in 2017 the Swiss financial regulator reduced the stringency of financial regulations applied to Swiss GSIBs in recognition of the fact that these banks had improved their resolvability. This development demonstrates an appropriately holistic view of financial regulation that should be adopted by other regulators as well.
Question 3: The Fed said the surcharges would be adjusted periodically for the effect of economic growth. By how much has economic growth changed the correct weights applied to bank characteristics to determine the GSIB surcharge?
The Fed said in 2015 that “the Board will periodically review the coefficients and make adjustments as appropriate” but has not yet done so. If the specific adjustments were implemented, the GSIB surcharges should be reduced by 19 basis points, on average, according to BPI.
Question 4: What is the economic cost of not making these adjustments?
A review by the Central Bank of the Netherlands finds that a 1 percentage point increase in capital requirements results in a 1.2 to 4.5 percent decline in lending to businesses and households, with a concomitant permanent decrease in economic activity. Thus, the economic cost of not reducing the GSIB surcharge by 1 ¾ percentage point translates to a 2.1 to 7.9 percent decline in loans held by U.S. GSIBs.
Question 5: In sum, should the GSIB capital surcharge be re-calculated to reflect structural changes in the banking system and the economy?
Any evidence-based approach to policy should systematically re-examine the basis for regulation. In calibrating the GSIB surcharge, the Federal Reserve Board issued a quantitative framework that guides its final calibration. There have been changes to the structure of the regulatory environment and the economy since the Fed calibrated the GSIB surcharge that would warrant updating the surcharges under the Fed’s framework. A capital regime that does not recognize and adjust to changing conditions in the banking sector and the economy will inevitably miss opportunities to promote financial stability, economic growth, or both.
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of the Bank Policy Institute or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.