3 Flawed Banking Industry Arguments Against a Key Postcrisis Capital Requirement
One element of financial reform that has been under threat over the past several months is the supplementary leverage ratio (SLR). The SLR is one prong of the capital requirements included in the Basel III international agreement—which U.S. regulators subsequently implemented—to address the drastic undercapitalization of the banking sector after the 2007-2008 financial crisis. Unlike risk-weighted capital requirements, the SLR takes into consideration all on-balance-sheet assets and off-balance-sheet exposures, such as derivatives contracts, without any regard to the riskiness of the assets. The SLR requirement only applies to banks with over $250 billion in assets, with an even higher enhanced SLR (eSLR) for the eight most systemically important banks, known as G-SIBs.
U.S. regulators finalized the SLR in 2014. In June, the U.S. Treasury Department released the first in a series of executive order-mandated reports on financial regulation, which included a recommendation to undermine the calculation of the SLR. Treasury’s recommendation would remove certain low-risk assets—cash held at central banks, Treasury securities, and initial margin for centrally cleared derivatives—from the denominator of the SLR. This change would undermine the risk-blind principle of the supplementary leverage ratio, while its practical impact would be to lower the loss-absorbing capital cushions at the largest banks by tens of billions of dollars each. The banking industry strongly supports lowering their capital requirements by changing the SLR and has put forward several flawed arguments to justify this change.
Argument 1: The SLR is a poor capital requirement because it does not take asset riskiness into account
The Clearing House, representing the largest commercial banks in the world, argues that the leverage ratio is not a good capital requirement because it is not sensitive to the risk of banks’ assets. The principle of the leverage ratio is to be a simple and transparent complement to the risk-weighted capital requirements that also apply to banks. There are positives and negatives associated with both types of capital requirements, but together, they work in tandem. The leverage ratio tends to incentivize banks to acquire riskier assets because the calculation is insensitive to risk. On the other hand, risk-based capital requirements incentivize banks to increase their leverage and are vulnerable to a mistake in calibration by regulators or gaming via financial engineering by banks. But the negative elements of one requirement are counterbalanced by the positives of the other requirement. If a bank is levering up and acquiring assets with low risk weights, it will bump into the leverage ratio that is risk blind. Conversely, if a bank with relatively low leverage starts loading up on highly risky assets, it will be constrained by the risk-weighted capital requirements.
The proposed changes to the SLR included in the Treasury report would essentially assign a 0 percent risk weight to those low-risk assets—undermining the entire principle of a complementary risk-blind leverage ratio. Interestingly enough, the Treasury report seems to endorse this principle:
Leverage capital requirements are not intended to adjust for real or perceived differences in the risk profile of different types of exposures … As such, the leverage ratio requirements complement the risk-based capital requirements that are based on the composition of a firm’s exposures.
However, the report offers a change that would clearly violate that principle.
Argument 2: The higher SLR for U.S. banks hurts their global competitiveness
When implementing the Basel III agreement, U.S. regulators opted for a higher supplementary leverage ratio on the largest U.S. banks than the level set in Basel III. The American Bankers Association (ABA) argues that this higher leverage requirement hurts American banking sector competitiveness globally. That charge, however, does not hold water when looking at the health and profitability of the U.S. banking sector compared to the relative weakness in the profitability of European banks. U.S. banks are in a much stronger position globally because of more robust financial regulations—not despite them. In November 2016, Gary Cohn, President Donald Trump’s current director of the National Economic Council and former president of Goldman Sachs, claimed that the current strength of U.S. banks is a competitive advantage for the U.S. economy. Regulations such as the SLR make the U.S. banking sector safer, more resilient, and, in turn, better able to lend throughout the entire economic cycle. When other countries see the strength and resilience of the U.S. financial sector, undergirded by strong financial regulations and rigorous enforcement, it creates a regulatory race to the top. Conversely, when the conversation in the United States shifts to loosening financial regulations for short-term bumps to already record-high bank profits, it creates the atmosphere for a global race to the bottom.
Argument 3: The SLR would harm the financial sector during a crisis
The ABA also argued that the current SLR calculation provides “incentive for banks not to serve as a safe haven for depositors in a crisis.” It is interesting that the ABA does not think banks will accept customer deposits—a cheap source of stable funding—during a financial crisis—especially considering that, during the last crisis, banks were starved for stable funding and had to rely on federal government liquidity facilities, bailouts, and guarantees to survive. During a crisis, most banks will be more concerned with the risks of current deposit withdrawals that can cause asset fire sales and threaten solvency—just ask Washington Mutual and Wachovia, both of which failed, in part, due to deposit withdrawals. Today, deposits are at their highest levels, and banks such as Goldman Sachs—which have not, historically, had a large deposit-taking business—are expanding those operations. Highly capitalized banks are a resilient source of strength for the U.S. economy. Furthermore, if some individual banks do receive an uptick in deposit growth, they should not be leveraged to the point where they are barely above regulatory minimums. Instead, they should allow for some prudent flexibility that may be required to handle volatility during a financial crisis. Higher loss-absorbing capacity in the banking sector will minimize the negative economic impacts of the next financial shock—not make those impacts more severe.
Treatment of custody banks
There are reasonable concerns, however, with how the risk-weighted capital requirements and the leverage ratio impact custodial banks—namely, the Bank of New York Mellon and State Street. Custodial banks provide a critical service to the U.S. economy. They specialize in the safekeeping of large quantities of assets for businesses, pension funds, endowments, and other institutions. Currently, the risk-weighted capital surcharge for G-SIBs varies based on the institution’s size, interconnectedness, complexity, cross-jurisdictional activity, and reliance on short-term funding. The leverage surcharge for these same banks, eSLR, does not vary across institutions. For example, the risk-weighted G-SIB surcharge for JPMorgan Chase is much higher than the risk-weighted G-SIB surcharge for State Street because JP Morgan is much larger, more interconnected, more complex, and has a larger cross-border footprint. But the eSLR is the same for both banks. This interaction makes it far more likely that the leverage ratio will be binding for the two custodial banks that have relatively low risk-weighted capital surcharges. As previously stated, the two requirements should work in tandem, and a single capital requirement should not be the only functional standard. Some proposals under consideration in Congress aim to address this issue by making a less severe—but, on principle, similar—carveout in the SLR calculation compared to what the Treasury report recommends. This is the wrong way to approach this issue. Creating calculation carveouts for certain banks or types of banks undermines the principle of the risk-blind leverage ratio. As the Systemic Risk Council—an independent organization that includes former senior financial regulatory officials from the United States and Europe—stated in their letter to Secretary Steven Mnuchin regarding the Treasury report recommendations, changes to the SLR calculation represent the “thin edge of a thick wedge.” Instead of chipping away at the SLR, regulators and Congress should give thought as to whether the G-SIB risk-weighted surcharge and eSLR should be proportional with one another and, therefore, both vary from G-SIB to G-SIB. This type of change would address the custody banks’ concerns while preserving the principle behind the capital calculations themselves.
Recent studies from the International Monetary Fund and Federal Reserve Board make a compelling case for even higher capital requirements. Today’s bank capital levels are at the low end of what is considered the socially optimal level of capital—the level that maximizes the benefits of avoiding a crisis while preserving lending and economic growth. Even the recent Treasury report on banking regulation that endorsed the SLR change has a line admitting that, “While some modest further benefits could likely be realized, the continual ratcheting up of capital requirements is not a costless means of making the banking system safer.” If some further benefits could be realized from stronger capital standards, why would the United States instead opt to weaken them? No changes should be made to capital requirements that have the net effect of lowering the capital cushions at the largest banks.
Lowering capital requirements by undermining the SLR is not a wise move for the American taxpayer or for the financial stability the U.S. economy needs in order to thrive.
Gregg Gelzinis is a special assistant for Economic Policy at the Center for American Progress.
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