On September 7, TCH Association President Greg Baer sent a letter to Senate Banking Chairman Crapo (R-ID) and Ranking Member Brown (D-OH) in response to an unsolicited letter sent by FDIC Vice Chair Thomas Hoenig in July. In his letter, Baer stated that: (i) raising capital requirements (by prohibiting dividends or otherwise) reduces, not increases, lending; (ii) barring returns of capital to shareholders would yield less, not more, lending; and (iii) large U.S. banks are not undercapitalized. In particular, the letter refutes Hoenig’s complaint that large banks had recently been returning too much capital to shareholders and his assertion that requiring the ten largest U.S. banks to retain a greater share of their earnings would increase lending by more than $1 trillion.
This blog post examines a related question: What incentive does the G-SIB surcharge create with respect to a bank’s decision to retain or distribute capital to its shareholders? Incentives arise here because the G-SIB surcharge is not a continuous function like other capital regulations. Rather, it proceeds in 50 basis point increments, or buckets, whereby a range of systemic scores yield the same capital surcharge. Thus, a bank operating towards the high end of a given bucket, and at risk of being forced to a higher bucket, must consider whether a marginal increase in lending or other activity can be justified given that such an increase would prompt an additional 50 basis point capital requirement against not just that business but to the entire balance sheet. Conversely, a bank operating towards the lower end of a given bucket would seem to have a powerful incentive to decrease lending or trading, as doing so would prompt a lower firm wide surcharge.
Below, we provide background on the Method 2 G-SIB methodology and present evidence that seems to suggest that these incentives are playing out in practice. In particular, our results indicate that if each of the eight G-SIBs were to retain all of their earnings earmarked for equity payouts over the next four quarters, the capital surcharge of five G-SIBs is estimated to increase 50 basis points. This analysis suggests that moving to a regime where G-SIB surcharges are a continuous function of systemic scores would incentivize banks to retain a higher share of their earnings, expand lending and boost economic growth.
The G-SIB surcharge
The systemic risk score calculated pursuant to the G-SIB assessment methodology is very important because it determines large banks’ capital and total-loss absorbing capacity (TLAC) requirements. The G-SIB assessment methodology has two objectives: (i) to identify globally systemically important banks, and (ii) to define the G-SIB capital surcharge for such banks. In the implementation of the G-SIB assessment framework, the banking agencies required U.S. banks to calculate their systemic indicator scores under two methods, with the higher of the two applying. The G-SIB capital surcharge obtained under the U.S.’s own method (also known as Method 2) was calibrated higher than the capital surcharge obtained under the Basel Committee’s approach. The U.S. method calculates the G-SIB score using five categories subdivided into 10 systemic indicators. The G-SIB score is equal to the sum of scores of each systemic indicator. Next, G-SIBs are assigned a specific capital surcharge based on their total systemic indicator scores. This mapping is done in increments of 50 basis points of capital surcharge for each 100-point fixed-width band of G-SIB systemic indicator score starting at 130. For example, a systemic score between 430 and 529 points corresponds to a capital surcharge of 2.5 percent relative to risk-weighted assets. Irrespective of their scores, all G-SIBs have a minimum capital surcharge of 1 percent.
Figure 1: G-SIB M2 scores and capital surcharges
Figure 1 plots the systemic indicator score and the corresponding G-SIB surcharge for the largest banks based on financial data for the six months ended in June 2017. In particular, as shown by the dots in the chart JPM, C, BAC, and to a lesser extent MS, are very close of experiencing an increase in their capital surcharge by 50 basis points. In contrast, GS and STT are very close to moving to the next lowest capital surcharge bucket and perhaps preparing to do so. Currently, the G-SIB buffer applicable to GS is 2.5 percent and it is based on year-end 2015 data. Our estimate uses data as of June 30, 2017 and yields a score just above the 3 percent threshold. GS’s second quarter 10-Q acknowledges the increase in the G-SIB buffer and attributes it mainly to an increase in the notational amount of short-term derivative contracts. The remaining large banks, WFC and BK are closer to the midpoint of the range of their current capital surcharge band. (This is also demonstrated in the memo item of Table 1).
Table 1: Estimated impact of balance sheet growth on G-SIB scores
Table 1 presents the results of our analysis on the impact of equity payouts on a bank’s G-SIB scores under Method 2. The first column of Table 1 shows the current fully phased-in G-SIBs surcharges, which will be effective on January 1, 2019. Although the G-SIB surcharge is in effect since the start of 2016, it is being phased-in and the current surcharge is equal to 50 percent of the applicable surcharge reported in column (1). In addition, the current G-SIB buffer is calculated using year-end 2015 systemic indicator scores and STWF data as of July 31, August 24, and September 30, 2015. The next two columns show the G-SIB surcharge and associated scores using banks’ most recent data on the systemic risk indicators. The most recent systemic scores are a better starting point for our analysis since it provides a more accurate assessment of banks’ current trade-offs between increasing their equity payouts and increase lending. The dividends and share buybacks each G-SIB is planning to distribute to its shareholders over the next year are reported in column (4). The following column, reports the change in total assets if all equity payouts were to be retained in the bank instead of distributed to its shareholders. The estimation in column (5), assumes each bank uses the additional equity to leverage the balance sheet in order to reach the current common equity tier 1 ratio. In addition, the extra funds are invested in a way that maintains the same ratio of risk-weighted assets to total assets (see note in Table 1). Finally, column (6) reports the estimated impact of the expansion of each bank’s balance sheet on its Method 2 G-SIB score using a regression model that estimates the relationship between the change in bank size and the change in the systemic indicators using historical data. Due to the lack of historical data for the short-term wholesale funding indicator, the change in the STWF score is such that its share on the overall score remains unchanged (at 29 percent).
Recall that the G-SIB surcharge uses 100-point fixed-width bands, thus the estimated change in systemic scores for 5 out of the 8 G-SIBs exceeds the change needed in systemic scores (reported in the memo item of Table 1) that would result in a 50 basis points increase in their capital surcharge. These results are summarized in Figure 2.
Figure 2: Estimated impact on surcharge of retaining one-year of equity payouts
As shown by our analysis, JPM, BAC, C, and to a lesser extent MS and WFC are very close to moving to the next G-SIB surcharge bucket. Since the relationship between systemic scores and G-SIB capital surcharges are governed by a step function, an increase in the systemic score of these banks would lead to a 50 basis point increase in their capital requirement. Similarly, GS and STT are very close to the lower bound of their current band, 5 and 2 points, respectively. These two banks therefore have an incentive to shrink their systemic footprint since they would be able to benefit from an immediate 50 basis point reduction of their capital surcharge. (One might even assume that this was in their plans.). In terms of policy implications, moving to a regime where G-SIB surcharges are a continuous function of banks’ systemic scores would incentivize banks to retain a higher share of their earnings and boost lending because the increase in retained earnings would not have such an abrupt impact on banks’ capital surcharges.
The systemic risk of banks as calculated pursuant to the G-SIB surcharge systemic indicator score is very important because it determines large banks’ capital and TLAC requirements. Our results indicate that if the largest G-SIBs were to retain a greater share of their projected earnings earmarked for dividends and share repurchases over the next four quarters, the G-SIB surcharges of JPM, BAC, C and to a lesser extent MS and WFC would likely increase 50 basis points. Thus, each of these firms has an incentive to distribute capital rather than retaining it, as doing so would lower its return-on-equity; put another way, they have an incentive not to increase lending, trading or other asset-intensive activities. A move to a regime where the capital surcharge is a continuous function of systemic scores would incentivize banks to retain a higher share of their earnings, expand lending and boost economic growth because a small change in a bank’s score would not lead to a large change in its G-SIB buffer.
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.