Big-bank capital buffer has advantages in current market: Fed's Brainard

WASHINGTON — With risks building in the financial system, it may make sense soon to employ for the first time a special capital buffer on the big banks meant to respond to market excesses, a top Federal Reserve Board official said Friday.

Federal Reserve Gov. Lael Brainard said there would be “several potential advantages to building additional resilience” gained from imposing the Fed’s countercyclical capital buffer in the near future.

The buffer would require the largest U.S. banks to hold additional capital while economic conditions are robust to counteract the elevated potential for riskier lending and to offset the potential losses that might come from those riskier activities.

Mark Kauzlarich/Bloomberg

“History suggests that we should not expect the market to provide incentives for banks to build the necessary buffers when times are good; the essence of the cycle is that market sentiment become overconfident precisely when risk is actually highest,” Brainard said in a speech at the Peterson Institute for International Economics. “One of the roles for independent regulatory bodies such as the Federal Reserve is to serve as a counterweight.”

Brainard added that the Fed's rule establishing the buffer suggested that the Fed should begin requiring more capital when financial vulnerabilities are only beginning to emerge, rather than when there are clear and present dangers to the economy.

“As a rough rule of thumb, the criteria for implementing the CCyB described in the Board’s framework of September 2016 are calibrated so that the CCyB will be above its minimum value of zero about one-third of the time — when financial vulnerabilities are assessed to be in the upper one-third of their historical distribution,” Brianard said.

And the Fed’s most recent financial stability report detailed the potential for precisely the kinds of risky losses that the CCyB was intended to counteract. The investment-grade corporate bond market seems to be heavily weighted on the lower end of the rating spectrum, Brainard said, meaning that a sudden downgrade from investment-grade to speculative-grade could spark a sell-off that might trigger broader economic stress.

Brainard noted that the corporate bond market includes bond funds containing certain blends of investment-grade and speculative-grade investments.

“These funds now hold about one-tenth of the corporate bond market, and the redemption behavior of investors in these funds during a market correction is unclear,” Brainard said. “Bond sales could lead to large changes in bond prices and overall financial conditions if technological, market, or regulatory factors contribute to strains on market liquidity — a possibility that has been relatively untested over the course of the expansion.”

Whether other members of the Fed board agree with Brainard’s assessment is uncertain. Last month, Federal Reserve Vice Chairman for Supervision Randal Quarles told the Brookings Institution that he doesn’t view the countercyclical capital buffer as a “macroeconomic damper” for cooling a hot economy, but rather is designed to be implemented “when we think financial stability risks are meaningfully above normal.”

And the Fed has already been under fire from the Trump administration for its monetary policy, which President Trump says is unfairly punitive and is dampening economic growth.