A recent Bloomberg editorial (“Fed’s Bank Stress Tests Are Facing a Stress Test,” Jan. 17) asserts that the Federal Reserve’s stress testing regime has provided a false sense of security, stating: “At the four largest US banks, loss-absorbing equity capital as a share of total exposure has declined significantly from its peak in 2017.” This assertion fails to acknowledge important changes in bank balance sheets and the level of risk they are taking.
Banks are subject to two kinds of capital requirements: risk-based ratios, which vary the required capital for a given asset with its risk; and leverage ratios, which require the same capital regardless of risk. The former requires a bank to hold less capital for a Treasury security than a subprime loan; the latter requires the same. The editorial ignores the former, and thereby paints a misleading picture.
Risk-based capital requirements for the four largest banks have increased from $662 billion at the end of 2017 to $747 billion in the third quarter of 2024 (Figure 1). Tier 1 capital held by those four banks increased from $743 billion to $847 billion in the same period. But the editorial — by reference to “total exposure” — instead focuses solely on the leverage ratios for those banks. On that basis, leverage capital ratios for those four banks have declined modestly (not significantly, as the editorial states) from 7 percent to 6.1 percent.
So why are risk-based capital levels significantly increasing while leverage capital ratios are modestly declining? Simple: banks are holding more low-risk assets, most notably Treasury securities (Figure 2).
So, in effect, the Bloomberg editorial is arguing that a bank that receives a customer deposit and uses that money to purchase a Treasury security needs to hold much more capital than it did before. A risk-based capital ratio would treat that as a riskless endeavor requiring no marginal capital increase, but a leverage ratio would require the bank to hold between 5 and 6 percent of the Treasury’s value as capital[1].
That divergence isn’t a call to action for banks to hold more capital; it’s a reminder of why the Federal Reserve and most global regulators have consistently taken the position that a leverage ratio should not be the binding capital requirement: that is, because it presents a misleading picture of bank condition and encourages banks to take more risk.
So, too, does the Bloomberg editorial.
[1] The exact percentage would depend on where within the bank the trade was booked.
