The purpose of the bank regulatory framework is to foster a safe and sound financial system, enabling banks to continue serving U.S. businesses and households, even amid periods of economic stress. Yet following the failure of Silicon Valley Bank (SVB) and other financial institutions in March 2023, the regulatory standards that underpin the nation’s banks were placed under scrutiny. The Federal Reserve, Federal Deposit Insurance Corporation (FDIC), and Office of the Comptroller of the Currency (OCC) issued proposals in July 2023 that would make important improvements to how risk is assessed and would raise the overall level of capital the largest banks would have to maintain. Collectively, these actions take critical steps to strengthen the banking system.
However, new empirical analysis from the Center for American Progress shows that the additions to bank equity are too small to substantially enhance banks’ stability. As regulators work to finalize their proposals in the coming months, they should consider further increases to bank equity to promote a safer and more resilient banking sector.
Understanding the need for stronger capital rules
For more than a year, regulators have been carefully considering adjustments to the capital requirements for large banks—those with assets of $100 billion or more. Capital requirements are among regulators’ most powerful tools in managing risky bank behaviors and reducing the likelihood of bank failures and taxpayer bailouts. These requirements determine how much of a bank’s loans and investments must be funded by money from its owners, as opposed to debt. Undercapitalization was a contributor to the 2007–2008 financial crisis and the instability in the banking sector early last year.
Bank capital: What is it, and why is it important?
Banks commonly depict “capital” as idle money they are required to hold to cover potential losses that cannot be used for lending or other purposes. This characterization is fiction. Banks are free to finance the assets on their balance sheet—the loans they make and the financial instruments they buy, such as corporate bonds or Treasury bonds—using both debt and equity. Regulatory capital requirements simply set a floor on the share of bank assets that must be financed with bank owners’ money. These capital ratios are intended to make banks self-insure against losses on their assets, which can lead to insolvency.
Debt includes the claims of depositors and other short- and long-term lenders to the banks, who purchase commercial paper or bond issues by the bank. Equity, meanwhile, refers to funding provided by bank owners through stock the bank issues or earnings it retains. When the value of a bank’s assets declines, the losses are first deducted from the value of bank equity, since the value of debt contracts is fixed. So long as assets have been financed with a sufficient share of equity, the bank will remain solvent—that is, the remaining value of assets will be large enough to satisfy debt payments as they come due. Bank creditors will recognize this, and there will be no incentive for uninsured depositors and other short-term lenders to withdraw their funds. By preventing runs and the attendant fire sale of assets, sufficient equity finance increases the stability of individual banks and the financial system itself.
By preventing runs and the attendant fire sale of assets, sufficient equity finance increases the stability of individual banks and the financial system itself.
Banks resist regulatory capital requirements, often by claiming that stability gains are offset by economic harms. One frequent claim is that equity finance is more expensive than debt, so increased equity requirements mean higher costs for bank-mediated finance. But this argument neglects the fact that lower leverage—that is, a lower share of debt in the bank’s funding mix—decreases the rate of return that equity owners expect to receive because bank solvency risk is reduced. This cost offset must be considered when examining the effects of increased capital requirements. For instance, a recent study summarized the literature on cost offsets in order to estimate their magnitude for U.S banks, concluding that increases in capital requirements have virtually no impact on the weighted average cost of capital for banks with assets of $200 billion or more, although the cost of equity is not fully offset for smaller banks. The study attributed the difference to the strength and scope of government guarantees to the “too-big-to-fail banks” and differences in the composition of bank assets and liabilities. Unfortunately, the earlier studies that the authors reviewed did not distinguish between bank sizes and thus were not helpful on this point.
From the point of view of overall economic performance, increased equity finance also has positive effects. Empirical evidence suggests that overall higher levels of bank equity improve both economic performance and the availability of credit. Indeed, research by economists at the Federal Reserve Bank of New York found that “an additional 100 basis points of bank capital reduc[es] the probability of negative GDP growth by 10 percent at the one-year horizon, even controlling for credit growth and financial conditions, and without a significant drag on expected GDP growth.” And earlier empirical work by economists at the Bank for International Settlements showed that banks with less leverage get more funding and make more loans.
In short, claims that the economy will suffer from increased equity requirements are questionable on empirical grounds.
Regulators’ proposals make important adjustments to the capital framework
The agencies’ July 2023 proposal to amend risk-based capital requirements for banks with more than $100 billion in total assets makes several important changes.
For example, it would reduce or eliminate firms’ reliance on internal models for calculating credit, market, and operational risks. Experts and global banking authorities have long acknowledged the challenges associated with the use of internal models, as they are sensitive to banks’ discretionary assumptions, and outputs vary greatly from firm to firm. The proposed changes would, accordingly, give regulators greater confidence in banks’ risk-weighting analyses.
Additionally, the proposal would require all banks with assets of at least $100 billion to include unrealized gains or losses on available-for-sale securities when calculating regulatory capital. Unrealized gains and losses are increases and decreases in the market value of assets the bank holds but has not yet sold. According to FDIC data, there are large unrealized losses for securities on bank balance sheets—about $620 billion as of the fourth quarter of 2022. That amounts to more than 10 percent of the value of all securities held on depository balance sheets at the end of 2022. Moreover, recent academic research shows that unrealized losses on securities and commercial and residential mortgages, taken together, amount to as much as $2 trillion. That is to say, the market value of assets on bank balance sheets is approximately $2 trillion less than the book or accounting value of those assets. If banks were forced to sell these securities or mortgages at current market prices, they could do so only at a discount to their nominal, or face, value—in other words, at a loss.
Recent academic research shows that unrealized losses on securities and commercial and residential mortgages, taken together, amount to as much as $2 trillion.
The proposal’s requirement that unrealized gains and losses be included in calculating regulatory capital is a welcome change. It is likely to have a limited effect on the ability of regulators to monitor declines in equity, since fair market value of securities holdings is already required in U.S. Securities and Exchange Commission filings. However, the proposed change would prevent banks from classifying securities as “held to maturity” in order to avoid recognition of losses in value. Instead, they would have to take the increased risk of violating regulatory equity minimums into account in their investment strategies.
The Federal Reserve separately issued a proposal that would improve the sensitivity of the U.S. global systemically important bank (GSIB) surcharge to systemic risk indicators. Collectively, these actions take important steps to strengthen the banking system.
Glossary of key terms
Types of capital
- Common equity Tier 1 (CET1) capital is the highest-quality and most loss-absorbing type of bank capital since it is comprised of instruments such as common stock and retained earnings:
- CET1 ratio = CET1 capital / total value of risk-weighted assets (RWAs)
- Tier 1 capital has two core elements: 1) CET1 capital and 2) additional Tier 1 capital, which is comprised of instruments such as noncumulative preferred stock that can absorb losses:
- Tier 1 ratio = Tier 1 capital / total assets
- Risk-weighted assets (RWAs): Risk-weights are assigned to assets according to estimates of the risk of those The higher the estimated risk, the higher the risk-weight factor and the greater the contribution of those assets to a bank’s total risk-weighted assets. The value of total risk-weighted assets is typically substantially below the value of total assets.
- Supplementary leverage ratio (SLR) compares a bank’s Tier 1 capital to its total leverage exposure, or the value of both on-balance-sheet assets and certain off-balance-sheet instruments such as derivatives, securities financing transactions, and loan commitments:
- SLR = Tier 1 capital / total leverage exposure
Despite proposed improvements, regulators can do more to address bank fragility
The agencies have estimated that under the proposed rules, there would be an increase in CET1 capital requirements amounting to 16 percent for all banks with $100 billion or more. In particular, there would be a 6 percent increase for banks with assets between $100 billion and $700 billion and a 19 percent increase for the U.S. GSIBs and other firms with assets of more than $700 billion. These estimates include changes in the way risk-weighted assets are calculated, changes in risk measures, and enhanced equity requirements for securities and derivatives trading.
Using the agencies’ estimates of the aggregate increases to CET1 capital, the Center for American Progress gauged the effects of the proposal on Tier 1 capital ratios and the SLR, other important measures used by the agencies to assess whether banks have sufficient capacity to survive financial shocks and remain solvent. The analysis found that in June 2023, the ratio of total Tier 1 capital-to-total assets for the eight U.S. GSIBs was 7.11 percent, while the ratio of total Tier 1 capital-to-total “leverage exposure,” the SLR, was 6.01 percent.
If the total amount of CET1 capital were increased by 19 percent, these ratios would rise to 7.23 and 6.11 percent, respectively. In dollar amounts, the proposed increase in CET1 capital would only increase aggregate Tier 1 capital among the U.S. GSIBs by about $17 billion. (see Figure 1)
While these are measurable changes, they do not substantially improve the financial stability of the GSIBs. Specifically, even under the new proposals, the SLR would likely still be insufficient to withstand shocks from recent history. We know from the 2007–2008 financial crisis that large shocks can reduce the value of bank assets by a far greater percentage. Quantitative estimates, based on data for the nine largest banks, show that had interventions by federal regulators not been successful, the potential loss of asset value from bankruptcy-producing runs would have been about 22 percent. In addition, we know that when Washington Mutual failed in September 2008, its losses amounted to 13 percent of its $310 billion in assets. Therefore, the increase in equity delivered by the recent agency proposals would not markedly improve the chances that the GSIBs would remain solvent in the face of shocks in the range of those historically observed.
Increased capital requirements for non-GSIB banks also appear to be inadequate. When SVB failed in 2023, its losses amounted to at least 17 percent of its assets. In the case of the closure of Signature Bank, also in spring 2023, losses were at least 11 percent of assets. The proposed 6 percent increase in required CET1 for firms similar in size to SVB and Signature would have left their Tier 1 leverage ratios unchanged at 8.1 and 8.8 percent, respectively. Thus, even with the new CET1 requirements, both SVB and Signature would have failed.
Although the risk of runs at large regional banks has receded, there is evidence that some of them are still experiencing stress. Banks continue to borrow from multiple Federal Reserve lending facilities, including Federal Home Loan Banks, at an elevated level, reaching a historical peak of nearly $1 trillion in the second quarter of 2023, before declining to more than $850 billion in the third quarter. This suggests that many banks continue to need help to avoid runs on deposits and associated asset fire sales that could make them insolvent. With greater equity finance, their operations would be better positioned to avoid insolvency without extraordinary support from regulators. The Federal Reserve, FDIC, and OCC should therefore consider greater increases to equity capital as they finalize their proposals.
Capital ratios were calculated by aggregating Tier 1 capital, assets, and leverage exposures across all eight U.S. GSIBs, then calculating aggregate Tier 1 leverage and SLR ratios using these values. The changes to these ratios reflect the required increase in CET1 bank capital.
For SVB and Signature, data do not yet exist on the total value of unpaid claims at the banks. Instead, the authors used estimates of the resolution costs to the FDIC, which include repaying depositors and administering the wind-up of the banks. Claims by unpaid general creditors may increase loss totals. For resolution cost estimates, see Martin J. Gruenberg’s remarks in “The Federal Regulators’ Response to Recent Bank Failures.”