Over the past year, we have frequently heard the argument that the countercyclical capital buffer (CCyB)—an additional capital requirement that the Federal Reserve can impose on the largest banks—should be increased because we are currently in “good times.” The argument is based on a fundamental misunderstanding of the role of the CCyB and other capital requirements. It would also violate the Fed’s own policy for setting the CCyB, which was finalized in 2016.
To our knowledge, the argument that the CCyB should be raised “in good times” was first put forward in a 2018 speech by Eric Rosengren, President of the Boston Fed. He describes the CCyB as a “rainy day fund” that a bank “builds up” during “good times” so that it can “deplete that fund during a recession, rather than shrink loans when the economy most needs them.” He illustrates his point by comparing how a bank would behave in a recession if it had extra capital that it could then deplete versus if it could only offset losses by shrinking its balance sheet. Significantly, his example assumes that it is known with certainty that a recession is coming and takes no account of the cost of the additional capital in good times (that is, most of the time).
He also failed to note that the largest banks are already required to hold another buffer for exactly that reason. It is called the capital conservation capital buffer (CCB), and it requires large banks to hold an additional 2.5 percent capital against their risk-weighted assets. The purpose, as described by the Basel Committee on Banking Supervision (BCBS), is “to ensure that banks build up capital buffers outside periods of stress which can be drawn down as losses are incurred.” Sound familiar? This is exactly the buffer the “good times” crowd is advocating for that can be built up in normal times, then depleted to lend steady in bad times.
Relatedly and implicit in some of the push to raise the CCyB is the notion that banks (and their regulators) are calculating their capital needs on the assumption that good times will continue, and thus will be caught short in the event that bad times come. Here we meet another capital requirement: the Fed’s annual stress test exercise. It explicitly requires banks at all times to hold enough capital to endure a financial crisis significantly worse than the 2007-09 global financial crisis, and still retain high enough capital levels to continue lending as if nothing had happened. Again, those seeking to raise the CCyB don’t generally include this fact in their equation.
What about the notion that the largest banks are systemically important, so we need to be extra certain that they don’t fail in a crisis, and therefore we should use the CCyB to require them to hold extra capital? Here we already have yet another buffer – the GSIB surcharge, imposed exactly for that purpose. As of the fourth quarter of 2018, the amount of extra capital held by the largest banks as a result of the GSIB surcharge is approximately $180 billion. This is on top of an additional $340 billion in capital that all banks are required to hold due to the CCB.
So, what is the purpose of the CCyB? Because times are normally “good,” an analysis of where capital requirements should generally be set “in good times” is the same as an analysis of where capital should be set in normal times. Roughly all efforts to estimate the best level of capital requirements in normal times do so by weighing the impact of the level of capital on the odds of a crisis against the impact of capital on economic activity. The logic of the CCyB is that when the likelihood of a crisis is higher than normal, the appropriate level of capital is higher than the normal level. But the Federal Reserve currently judges that the likelihood of a crisis is moderate, not elevated, in large part because bank capital levels are so high. Federal Reserve Vice Chair for Supervision Randal Quarles recently affirmed this view, stating that “Taken as a whole, financial system vulnerabilities strike me as being not outside their normal range, which is consistent with a zero CCyB under the Board’s framework.”
Returning to Rosengren’s example, if one takes into account the uncertainty of when a recession will occur and the lower economic activity and employment resulting from higher capital requirements, the question “should the CCyB be above zero?” converts to “what is the right level of capital in normal times?” (As we noted in a blog post at the time, if Rosengren’s objective is simply to be able to reduce capital requirements in stressful times, that can be accomplished by allowing the CCyB to be made negative.)
It is presumably because the other components of capital requirements are calibrated to be appropriate and sufficient in “good times” that both the BCBS, when designing the CCyB, and the Fed, when adopting it, concluded that the buffer should only be used when risks were elevated. The first principle for using the buffer established by the BCBS is:
Principle 1: Buffer decisions should be guided by the objectives to be achieved by the buffer, namely to protect the banking system against potential future losses when excess credit growth is associated with an increase in system-wide risk.
Additionally, the BCBS notes that as a result of this focus excess credit growth, the buffer is likely only to be deployed on an “infrequent” basis.
Jurisdictions are encouraged by the BCBS to use the detrended credit-to-GDP ratio as the main guide for assessing if conditions warrant raising the CCyB. According to the Bank for International Settlements (the home of the BCBS) estimates, as of 2018Q4, the credit-to-GDP gap in the United States is -6.9 percent. That is, by this measure the likelihood of a financial crisis in the United States is well below normal, not above normal.
In the regulation adopting the CCyB, the Fed begins by stating
The CCyB is designed to increase the resilience of large banking organizations when the Board sees an elevated risk of above-normal losses…the Board would most likely begin to increase the CCyB above zero in those circumstances when systemic vulnerabilities become meaningfully above normal…
The regulation also states the situation when the CCyB would be left at zero:
Generally, a zero percent U.S. CCyB amount would reflect an assessment that U.S. economic and financial conditions are broadly consistent with a financial system in which levels of system-wide vulnerabilities are within or near their normal range of values.
Therefore, raising the CCyB now would require a change in the CCyB regulation, since current financial conditions don’t meet the Board’s trigger for implementation. In a recent speech discussing the CCyB’s place in U.S. capital regulations, Vice Chair Quarles provided additional details on why the CCyB should be kept at zero in most cases: “A notable feature of the Board’s current framework is the decision to maintain a 0 percent CCyB when vulnerabilities are within their normal range. Because we set high, through-the-cycle capital requirements in the United States that provide substantial resilience to normal fluctuations in economic and financial conditions, it is appropriate to set the CCyB at zero in a normal risk environment. Thus, our presumption has been that the CCyB would be zero most of the time.”
In his remarks about the Fed’s first Financial Stability Report, released at the end of November, Jay Powell, Chairman of the Federal Reserve, summed up the report as follows:
My own assessment is that, while risks are above normal in some areas and below normal in others, overall financial stability vulnerabilities are at a moderate level.
Furthermore, he noted that in the July 31 to August 1 FOMC minutes, “the staff assessed financial stability vulnerabilities as moderate.”
Thus, judging by both the BIS’s favored indicator and the Fed’s holistic assessment, the current risk of a financial crisis is normal, not elevated, so the situation continues to call for a CCyB of zero.
The logic that the Fed tighten in good times and ease in bad times is impeccable, but it is guidance for monetary policy, not regulatory policy. When the Fed tightens and eases monetary policy, it influences the economy broadly. When it tightens and eases regulatory policy on a small set of banks, the consequences are borne by the businesses and households that are customers of those banks.
A final note that even if the Fed were to determine that the assessment of risks called for imposition of a CCyB above zero, in accordance with the Administrative Procedures Act (and as noted in their own policy), they would need to provide a formal notice raising requirements and provide institutions with an opportunity to comment on the proposed increase. While the proposed CCyB policy did not include any reference to a comment period, in response to a letter written by The Clearing House Association (BPI’s predecessor), the Fed added explicit reference to providing an opportunity to comment into their final policy statement.
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.