On the first day of every FOMC meeting not followed by a press conference (such as today), the Fed receives a briefing on financial stability. Based on recent communications, it seems likely that the Fed may discuss raising the counter cyclical capital buffer (CCyB) to enable it to maintain an accommodative stance of monetary policy. The CCyB—a component of the Basel III capital framework—is an additional capital charge on the largest banks that can be applied when the Board sees an elevated risk of above-normal losses, particularly when there is rapid asset price appreciation or credit growth that is not well-supported by underlying economic fundamentals. Raising the CCyB would be a bad idea.
The Fed is currently concerned about the possibility that easy monetary policy might be warranted but lead to financial instability. At its March 20-21 meeting, the Federal Open Market Committee (the monetary policy-setting arm of the Fed) discussed the advantages and disadvantages of leaving interest rates low and letting the economy run a little hot for a while. The discussion is described in the minutes to the meeting:
A number of participants offered their views on the potential benefits and costs associated with an economy operating well above potential for a prolonged period while inflation remained low. On the one hand, the associated tightness in the labor market might help speed the return of inflation to the Committee’s 2 percent goal and induce a further increase in labor force participation; on the other hand, an overheated economy could result in significant inflation pressures or lead to financial instability .
In two speeches since then, Gov. Lael Brainard, a member of the FOMC, has noted that the CCyB provides the Fed an additional tool it can use to address financial imbalances, enabling it to maintain accommodative monetary policy. In both speeches, she used the same words:
Countercyclical capital requirements can lean against a dangerous increase in financial vulnerabilities at a time when the degree of monetary tightening that would be needed to achieve the same goal would be inconsistent with the Federal Reserve’s dual mandate of full employment and price stability.
But raising the CCyB would be bad policy for several reasons. First, the Board’s regulation implementing the CCyB states that it will raise the CCyB when financial system vulnerabilities are “meaningfully above normal” based in part on Fed staff’s quarterly assessment of financial stability. According to the February 2018 Monetary Policy Report to Congress, the Fed currently sees vulnerabilities as “moderate,” which we take to mean below “meaningfully above normal.” The report goes on to state that, while asset valuation pressures are “elevated,” those high asset prices are offset by “…capital and liquidity ratios of banks that have continued to improve from already strong positions.”
Even if “valuation pressures” were to worsen (that is, if equity, house, and commercial real estate prices rise further and business borrowing costs were to fall), the appropriate response would not be to raise the capital requirements on the largest banks. As we explain in a previous blog post, using the BIS’s estimates of costs and benefits, raising the CCyB would only provide net benefits if the probability of a financial crisis were similar to the probability prior to the crisis, much higher than anyone is arguing they are now.
Second, the Fed’s stress tests, which are just wrapping up, already ensure that the largest banks (and only the largest banks, which are subject to those tests) have enough capital to deal with “financial imbalances.” As described in a recent post by my colleague Francisco Covas, the stress test scenario this year includes declines in equity, house, and CRE prices, and a widening in BBB spreads, that are materially more sudden and severe than occurred in the recent financial crisis. Thus, the Fed has already ensured that the largest banks are capable of withstanding an unprecedented unwinding of imbalances combined with a recession more severe than the great recession.
Lastly, the CCyB is poorly suited to achieving Gov. Brainard’s stated goal — “lean[ing] against a dangerous increase in financial vulnerabilities.” Even the Fed and the Basel Committee seem unconvinced that the CCyB can be used to correct building financial imbalances: In promulgating the CCyB, the Fed emphasized the potential for the buffer to reduce the costs of the crisis rather than the probability. Specifically, in describing the purpose of the CCyB, the Fed says the “CCyB is designed to increase the resilience of large banking organizations when the Board sees an elevated risk of above-normal losses.” The rationale then adds, “…the CCyB also has the potential to moderate fluctuations in the supply of credit over time.”  The Basel Committee on Bank Supervision, the body that designed the CCyB, appears to see the potential benefits similarly. The consultative document that proposed the CCyB states the purpose of the CCyB is to buffer banks from a crash after a boom, but that moderating boom is at best a side benefit that is “…not yet well understood.”  Increasing capital requirements by potentially tens of billions of dollars on large banks is a major step, and a step that one would hope the Federal Reserve would not take for benefits that are only possible and not well understood.
There are good reasons to conclude that the CCyB would not effectively put the brakes on building financial imbalances — that is, help deflate bubbles in asset prices or improve widespread deteriorations in credit standards. The CCyB only applies to 15 banks, and while those banks hold a large percentage of the assets of the banking system, they are only about one-eighth of the financial system. Risks could always migrate outside of the banks subject to the CCyB. Indeed, that is exactly what two Fed working papers concluded occurred in the case of the 2014 leveraged lending guidance, a similar exercise in macroprudential supervision. Both papers found that the guidance had the effect of shifting leveraged lending origination activity away from large banks and towards less regulated market participants, with no meaningful reduction in any systemic risks posed.
While no one is calling for an immediate increase in the CCyB as far as we know, the monetary policy debate has clearly gone beyond the simply hypothetical. The FOMC participants’ economic projections provided at the March meeting show inflation moving above the Committee’s 2 percent target in 2020—a characteristic of mild overheating—the first time that they have actually projected an overshoot. We hope that they are not also projecting an increase in the CCyB, a capital hike that would be both costly and unhelpful.
Disclaimer: The views expressed in this post are those of the author(s) and do not necessarily reflect the position of The Clearing House or its membership, and are not intended to be, and should not be construed as, legal advice of any kind.