Congress Flirts With Disaster on Bank Leverage Ratios
The stock market’s recent volatility is a reminder that financial conditions can change quickly. Whether periods of stress turn into severe economic downturns depends in large part on whether the nation’s major banks are sufficiently capitalized to weather the market’s ups and downs.
Regulators have worked hard to increase bank capital levels since the 2008 financial crisis, when major U.S. banks collapsed under the weight of their own debt obligations. It is alarming that several senators are now considering legislation that would weaken a key constraint against excessive leverage.
The Economic Growth, Regulatory Relief and Consumer Protection Act is a bipartisan bill that contains many good provisions to help community and regional banks. But one provision, Section 402, would shortsightedly enable banks to increase their reliance on debt. It is a technical change, but it needs to be understood, as it could undermine an important guarantor of financial stability and recreate part of the dangerous pre-crisis status quo.
In setting capital requirements prior to the financial crisis, regulators erroneously judged certain assets—such as mortgage securities, derivatives and European sovereign debt—as having little if any risk. Banks piled into these assets because regulators let them leverage returns with borrowed money.
Because their judgments about risk had been so wrong, regulators after the financial crisis have made greater use of capital standards that don’t rely on government risk assumptions. For big banks, the most important of these is the “supplemental leverage ratio,” which requires big banks to fund themselves with at least 5% common equity, effectively limiting their reliance on debt to 95%.
Section 402 would weaken this modest constraint on leverage by excluding central-bank deposits from this debt-to-equity ratio. This includes deposits not only at the Federal Reserve but also at central banks in countries not always viewed as paragons of stability, such as Turkey and Greece.
Big banks keep a lot of money on deposit with central banks, so removing those deposits from the leverage calculation could lead to capital reductions approaching 30% at some banks. The bill intends to limit these capital reductions to “custodian” banks, usually understood to mean specialized banks that safeguard customer assets. But the bill’s definition of “custodian” bank is so broad that any big bank might qualify.
The stated purpose of the Senate bill is to realign incentives in the financial sector to support economic growth. But Section 402 will not encourage banks to make business and consumer loans; it will simply encourage them to park money with central banks so they can take on more leverage. In fact, with this provision, they can take clients’ near-zero-interest-rate deposits and place them in their entirety at the Fed, where they will earn a 1.5% return—an effortless way to make a profit that will become more attractive as the Fed raises rates later this year.
One possible argument for Section 402 is that the new incentive to invest will help expand central banks’ balance sheets, strengthening their ability to fight economic crises. Late last year, the Basel Committee, an international regulatory forum that includes central-bank supervisors, expressed some sympathy for removing central-bank deposits from the leverage ratio, but only temporarily and amid exceptional macroeconomic circumstances. Even assuming quantitative easing is a worthwhile strategy, however, this legislation is not necessary to facilitate it. The Fed already has the power to ease capital requirements temporarily to support its market interventions.
Of all the Basel Committee member countries, only the Brexit-challenged U.K. has taken the step of removing central-bank deposits from its leverage calculation. Notably, it also increased its leverage ratio to mitigate the reduction in capital levels, something the Senate bill does not do.
Why does Congress think it is wise to designate particular banking activities as low- or no-risk when expert financial regulators failed so spectacularly in this exercise prior to the crisis? The virtue of the existing leverage calculation is that it does not reflect government judgments about risk. Central-bank deposits might appear to be low-risk today, but other items could be added to the list tomorrow. The Treasury wants U.S. government securities removed from the leverage ratio, notwithstanding their significant interest rate risk. What’s next? Housing agency debt? How about triple-A-rated corporate bonds? Section 402 will create an uneven playing field by giving big systemic banks a special capital break not applicable to community and regional institutions.
Government judgments favoring one financial activity over another inevitably distort and weaken markets. It would be the height of irresponsibility for Congress to loosen capital requirements now, when big banks need to prepare for rough times that may lie ahead. Capital buffers should be built up, not chipped away.
Ms. Bair was chairman of the Federal Deposit Insurance Corp from 2006-11 and is currently founding chair of the Systemic Risk Council.
Appeared in the February 13, 2018, print edition.