Big Banks Will Game New Capital Rules, Lawmakers Fear

WASHINGTON — Lawmakers pressed regulators Thursday about the significance of new capital rules and a separate proposal to raise the leverage ratio on the largest banks, raising fears they could still allow institutions to effectively "game" the system.

Sen. Sherrod Brown, D-Ohio, praised regulators for suggesting an increase in the leverage ratio, but said it did not go far enough, citing media reports that said large institutions plan to use "optimization strategies," instead of more capital, to comply with the new rules.

"I'm particularly concerned that banks can use risk weights and internal models to game their capital rules," Brown said during a Senate Banking Committee hearing on systemic risk.

He was seconded by Sen. David Vitter, R-La., who said the proposed supplemental ratio, which would boost requirements for holding companies to 5% while their insured subsidiaries face a 6% requirement, is insufficient.

"I continue to be concerned, while this is a very important step I think in the right direction, that it's not a significant enough number," said Vitter. "It strikes me, in particular, that you look at smaller banks, community banks, without any regulatory requirement, they're way above this."

At issue are two related but separate regulations. Federal regulators finished signing off this week on final Basel III capital rules that establish new risk-based capital requirements for all institutions. Many regulators, including Federal Deposit Insurance Corp., have raised fears that these risk-based requirements can be manipulated, however.

As a result, regulators included a 4% leverage ratio within the final Basel III rules for all banks and issued a separate proposal to add an additional supplemental leverage ratio on the biggest eight banks.

During the hearing, Federal Reserve Gov. Daniel Tarullo said regulators were mindful of potential manipulation, but downplayed such concerns. He noted that prior to the advent of risk-based rules, banks found ways to game basic leverage ratios.

"What we saw with savings and loans, then famously with Continental Illinois, was that the banks were gaming the leverage ratio by taking the most risk they could for a given amount of leverage," Tarullo said. "It was at that moment when the regulators began to say they needed something else which looked at the actual amount of risk the bank was taking. So thus was born the concept of risk-weighting, which saw its way into the Basel I agreement."

Tarullo said the solution was to use a mix of approaches, noting that the Basel III rules include both risk-based and leverage requirements. He also cited regulatory stress tests designed to ensure banks cannot manipulate capital requirements.

"I think those three things together provide a quite solid base, each of which compensates for the potential shortcomings of the other," he said.

He was backed by Comptroller of the Currency Thomas Curry, who said the leverage ratio was proposed to ensure risk-based requirements did not result in a decrease of capital overall.

"We … view the supplemental leverage ratio as basically belts and suspenders to make sure we have a properly calibrated leverage ratio that works well with the existing risk-based capital regime that we have in place," he said. "It's a judgment call on how high and how fast to push [the leverage ratio] up. The level we proposed is a substantial increase by our estimates."

Curry said that if the proposed supplemental ratio had been in place in the third quarter of last year, it would have required banks to hold an additional $90 billion of capital while holding companies would have to hold more than $60 billion.

"We think it creates rough comparability with the strengthening on the risk-based side in Basel III," he said.

Yet regulators also reiterated they are not finished with crafting capital rules and other regulations designed to curb systemic risk. Tarullo said that the Fed is inching closer towards proposing a long-term debt requirement for the largest banks in the fall. Such a requirement would help regulators unwind a failing behemoth, he said.

"There's still some technical issues being worked through, but I think we've got a sense of how we want to go about making sure that the resolution of a large, systemically important firm could proceed smoothly," he said.

Tarullo also reiterated that the central bank is still focused on the dangers of short-term wholesale funding. Regulators are hoping to issue an advanced notice of proposed rulemaking to address that issue in the "early fall," he said.

"The major vulnerability that remains is that associated with large amounts of runnable, short-term funding," Tarullo said. "What we want to do is, in an advance notice of proposed rulemaking, get out some ideas as to how we might address that, certainly with respect to the very large institutions."

FDIC Chairman Martin Gruenberg and the OCC's Curry said that their agencies will be primarily focused in coming months on collecting and reviewing comments on the newly proposed leverage ratio. None of the regulators gave a specific timetable for when that plan might be finalized.

Somewhat surprisingly, the pending Volcker rule, a highly anticipated and long-delayed ban on proprietary trading, took a backseat to the discussion on capital.

Lawmakers didn't probe regulators for more detail about when the rule might be finalized or how they were potentially looking to amend it, which were common concerns at past hearings. Tarullo said in his written testimony he "maintain[s] both the hope and expectation" that regulators can finalize the rule by the end of the year.

As lawmakers look at the third anniversary of Dodd-Frank approaching next week, they said they expect to complete most major rulemakings by the end of the year.

"We are closer to the end than the beginning here," said Mary Miller, Treasury undersecretary for domestic finance.

During the hearing, however, some lawmakers pursued other issues.

Sen. Elizabeth Warren, D-Mass., shifted the conversation back to her longstanding concern that some large banks may be "too big to prosecute," warning that regulators don't have enough leverage in negotiating with institutions if companies know that the government is likely to settle rather than go to trial. She pointed to recent comments by Mary Jo White, chairman of the Securities and Exchange Commission, who said the agency would require an admission of guilt in a wider range of cases it settles, asking if the banking regulators were prepared to do the same and "be tougher" on banks.

"Now the SEC has said it will be tougher when large numbers of investors have been harmed intentionally or when the defendant unlawfully obstructs the commission's investigative process," Warren said. "I think the same principles that apply to the SEC enforcement would also apply to other regulators. So my question is whether or not you've considered moving in the same direction as Chair White on admission of guilt policies?"

Tarullo was sympathetic to some of Warren's concerns, though he repeatedly pointed to the different roles the agencies play, noting that the Fed has significant supervisory powers, while an agency like the SEC is more involved in enforcement.

"For us with prudential regulation, we are basically trying to protect the taxpayers. What we're most interested in is making sure that any … unsafe and unsound practices are remedied as quickly as possible," he said. "Given the tools and the abilities we have and the effort to maximize the benefits to the public of the resources that we do have, generally speaking, the use of supervisory mechanisms I think is probably most effective."

Still, he acknowledged that more transparency around the Fed's enforcement efforts could be a positive step.

"If one is talking about the transparency of enforcement actions no matter what their origins — law enforcement, regulatory, administrative, supervisory — I actually do think that the bank regulators need to think more about when we put out the public notice of the kinds of supervisory actions that have been taken," Tarullo said. "In a somewhat different context, we've moved a long way with stress tests and the publication of results on the stress tests. I think there's a pretty good case to be made for thinking about putting enforcement actions — orders that we will use, as you say, internally, out on the public record as well, which I think does serve some of those purposes."