Capital Punishment?

credit: macrobuiness.com.au

Was it capital punishment at today's meeting of the Board of Directors of the Federal Deposit Insurance Corporation (FDIC)?

Nope, not capital punishment, just a recipe for a better night's sleep and, with the supplemental leverage ratio proposal, the foundation for a safer, sounder, and more prosperous banking system in the United States.

I was watching the live webcast of today's meeting of the FDIC Board of Directors with intense interest.  Because yesterday, CNBC reported that the FDIC would propose a 5% common equity to assets leverage ratio for the largest and most interconnected U.S. banks - the global systemically important U.S. financial institutions.

The pure joy of such a potential development was driven to exhilarating heights as it comes on the heels of a troubling Basel III report just released by the Bank for International Settlements - the Vatican for Basel III worshipers.   

The Basel Committee on Banking Supervision just released a study,  Regulatory Consistency Assessment Programme (RCAP): Analysis of risk-weighted assets for credit risk in the banking book.   The study looks at risk weighting done by the world's largest banks, using their own models, with regard to the internal ratings-based approach (IRB) to credit risk - an "advanced" Basel III approach.  The report confirms that risk weights for credit risk in the banking book vary significantly across banks.  In fact, during a hypothetical portfolio bench-marking exercise: "...risk weight variation could cause the reported capital ratios for some outlier banks to vary by as much as 2 percentage points from the benchmark (or 20% in relative terms) in either direction."  

That, folks, is what passes as an advanced scientific approach to bank capital regulation!

The FDIC board meeting was a refreshing, but not a totally satisfying, event.  The Board took two substantive votes.  First, the Board voted on an interim final rule for domestic bank capital regulation that was substantially similar to that approved by the Board of Governors of the Federal Reserve System last week.

The vote was 4-1 with Director Hoenig dissenting primarily on the issue that a domestic capital rule should not be promulgated with, what almost everyone seemed to agree, was an inadequate supplementary leverage ratio.

The other vote was on an interagency Notice of Proposed Rulemaking (NPR) on a higher supplementary leverage ratio for the largest U.S. bank holding companies (BHCs).  The vote?  Unanimous for the NPR.

Under the proposed rule, top-tier bank holding companies with more than $700 billion in consolidated total assets or $10 trillion in assets under custody (covered BHCs) would be required to maintain a tier 1 capital leverage buffer of at least 2 percent above the minimum supplementary leverage ratio requirement of  3 percent, for a total of 5 percent.  The leverage buffer would function like the capital conservation buffer in the  previously-approved domestic capital rule. Failure to exceed the 5 percent ratio would subject covered BHCs to restrictions on discretionary bonus payments and capital distributions.  In addition to the leverage buffer for covered BHCs, the proposed rule would require insured depository institutions of covered BHCs to meet a 6 percent supplementary leverage ratio to be considered "well capitalized" for prompt corrective action purposes.

The supplementary leverage ratio includes many off-balance sheet items and, like all capital minimums, banks are expected to maintain a cushion comfortably above these capital floors.

The proposed rule would currently apply to the eight largest, most systemically significant U.S. banking organizations - JPMorgan Chase & Co., Citigroup Inc., Wells Fargo & Co., Goldman Sachs Group Inc., Bank of America Corp., Morgan Stanley, State Street Corp., and Bank of New York Mellon Corp.

Plaudits to federal bank regulators today!  While the proposed supplementary leverage ratios may not be as high as some might prefer, federal bank regulators, looking out for the best interests of the U.S. economy, deserve positive recognition for well-executed public service.  They fought the pressure to lower leverage ratio minimums to levels that, internationally, would allow certain large European and Asian banks to appear properly capitalized, while also simultaneously strengthening the U.S. banking system.

As far as the FDIC board meeting not being totally satisfying, unfortunately we are prisoners of an old high school debate tactic...(s)he who frames the issue, controls the argument  (or in the realm of regulation-writing... (s)he who holds the pen, controls the draft).  The basic leverage ratio has been "tagged", by the risk-based capital regulation proponents, as a supplemental, and therefore secondary, capital measure since the inception of the risk-based capital regulation movement decades ago.

The basic leverage ratio has always been framed by the Basel Committee as the poor second cousin of the risk-based approach to capital regulation.  You know, something for the old-fashioned folk who prefer a mug of simple leverage beer to either a chilled glass of risk-based standardized approach Chardonnay wine or a nose-tingling flute of Advanced IRB Champagne.

In a do-over, I would prefer a doppelgänger world where the overly complex and easily gamed risk-based capital approach is itself supplemental to the basic leverage ratio.  The risk-based capital approach being a useful, though imperfect... additional, but not driving... capital surveillance tool.  

My biggest concern is not about risk-based capital regulation's over-complexity, leviathan-sized regulation books, nor the natural propensity for larger banks to game or circumvent the system.  My biggest concern is that risk-based capital regulation has a subterranean steering current that is the covert precursor to a potential world of capital-incentivized bank credit allocation by the Federal government.

Note how the risk-based capital rules follow the political winds when it comes to OECD sovereign debt, public sector enterprises (like the busted Fannie Mae and Freddie Mac), and real estate lending.  In the hands of some future government officials, who may be less sympathetic to the benefits of market capitalism, risk-based capital regulation becomes the slippery slope toward potential bank credit allocation by government incentive, rather than mandate.  Basic leverage ratios, on the other hand, are economic libertarians.

It's not cause to build a bomb shelter or hoard six months worth of food, but it is important to think about the impacts and implications of the regulatory momentum and inertia we have built up on the path we are presently following.  How will our present actions impact the future structure, operation, and risk profile of the U.S. banking system?