Regulators Aren’t Enabling Risk by Reproposing Basel – They’re Following the Law.

A recent Bloomberg editorial criticized bank regulators for mitigating a proposal to require larger banks to significantly increase their capital levels. The editorial argues that the current capital requirements are insufficient, arguing that banks historically held much higher equity ratios and that academics recommend funding at least 15 percent of assets with equity.

This post rebuts the editorial by making four key points. First, it clarifies the difference between risk-based capital ratios and leverage ratios, which the editorial conflates or misunderstands. Second, it demonstrates that current capital levels are adequate by citing data showing U.S. banks' capital ratios have doubled since the financial crisis and fall within the optimal range suggested by academic studies. Third, it explains that industry opposition to the Basel proposal stems from procedural concerns and lack of evidence justifying the increase in capital requirements. Finally, it notes that while the industry supports removing the AOCI filter to address issues similar to those in recent bank failures, most of the Basel proposal is not related to the causes of these failures.

Issue #1: Conflating Different Capital Requirements

The editorial appears to confuse leverage ratios with risk-based capital ratios, though it does not cite any specific requirement. These two kinds of capital requirements have an important distinction. A leverage ratio treats all assets equally, while a risk-based ratio assigns different weights to assets based on their perceived risk. For example, risk-based ratios assign a risk weight of zero to banks' deposits at the Federal Reserve - which are riskless, fully liquid assets - whereas leverage ratios would assign a risk weight of 1, requiring the bank to hold the same amount of capital as it would for a subprime loan.

Currently, risk-based requirements vary by the size, risk, complexity and systemic importance of a bank, ranging between 7 percent and 18.4 percent of risk-weighted assets.

The leverage requirement is 5 percent for the largest banks and 3 percent for banks above $250 billion in total assets that are not classified as Global Systemically Important Banks (GSIBs).

Regulators have consistently stated that leverage ratios should be a backstop rather than a binding constraint, because they are a less accurate measure of risk and, when binding, give banks an incentive to take greater risk - that is, with the capital requirement the same, hold the one with the higher yield. And leverage ratios discourage banks from acting as dealers in low-risk assets, such as U.S. Treasury securities.

The best illustration of the problem with leverage ratios came in 2020 when in reaction to the COVID-19 pandemic, when the Federal Reserve engaged in massive asset purchases to support the economy and funded them by injecting $1 trillion in reserves into the system. Those reserves - cash deposits at the Fed - appeared as assets on bank balance sheets. This had no effect on risk-based capital ratios but significantly lowered their leverage ratios - suggesting they needed an additional $50 billion (5 percent) of capital to fund the additional $1 trillion in assets. The Bloomberg editorial considers this drop in leverage capital ratios as evidence that U.S. banks require a capital increase under Basel.

Issue #2: What Is A 'Just Right' Amount Of Capital?

The editorial also suggests that banks do not have enough capital, but a look at the relevant economic literature demonstrates the opposite: the key capital ratio for U.S. banks falls well within the range of optimal capital. Figure 1 plots the common equity tier 1 (CET1) risk-based capital ratio of U.S. banks from 2001 to the present. As illustrated, the capital of U.S. banks has more than doubled since its lowest point during the Global Financial Crisis, largely due to Basel-related regulatory changes. The chart also indicates the midpoint of the optimal capital range as reported in several academic papers.

According to these academic papers, the optimal level of bank capital is that which maximizes lifetime consumption for households in the economy. The primary benefit of higher bank capital is a reduced probability of bank failure and therefore higher GDP from improved economic conditions. In contrast, the main cost of higher capital requirements is a smaller banking sector, resulting in decreased business borrowing and investment, along with a decline in GDP. Optimal capital balances these tradeoffs as closely as possible. These academic papers provide estimates that range from 6 percent to 14.5 percent, with a midpoint of 10.3 percent. Hence, the current CET1 capital ratio of U.S. bank holding companies, as measured using existing RWA calculation methodologies, falls well within the range of optimal capital ratios.

Issue #3: Why Does The Banking Industry Oppose The Basel Proposal?

Third, the editorial misconstrues the reason for industry opposition to the Basel proposal; it stemmed from several legal and procedural concerns regarding the proposed banking capital rule. Key issues included insufficient data to support the proposed changes to capital requirements, failure to consider overlaps between the proposed capital requirements and stress tests and an inadequate economic impact analysis.

Moreover, the proposal would significantly increase capital requirements without evidence that current levels are insufficient (see Figure 1), contradicting statements by agency officials that banks are well-capitalized. For these reasons, we have urged regulatory agencies to issue a new proposal addressing the deficiencies of the original one.

Issue #4: The Basel Proposal Isn't About SVB

Lastly, the editorial forges a link between the spring 2023 bank failures and the Basel proposal when these are separate issues. The industry supports the removal of the AOCI filter for all banks above $100 billion in assets. This change will require banks to increase their capital when unrealized losses on available-for-sale securities increase (and vice versa), addressing issues similar to those faced by Silicon Valley Bank in March of 2023. However, no other elements of the proposal relate to the bank failures of March 2023.

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