Fed's New Capital Plan Stokes Skepticism

WASHINGTON — Both banks and Wall Street critics supported the Federal Reserve Board's proposal to implement a countercyclical capital buffer on megabanks — but the two camps offered widely differing visions on how the buffer would work in practice.

The agency released a plan Monday that would set the buffer between 0% and 2.5%, allowing the Fed to raise capital requirements when it detects heightened risk in the financial system.

Consumer advocates saw the proposal as a key element in preventing the next crisis because it gives the Fed a mechanism to compel banks to retain profits during good economic times.

"Ensuring that there's a capital buffer through the business cycle is imperative to trying to prevent the next financial crash," said Dennis Kelleher, the president of Better Markets. "People forget, but in 2004, 2005 and 2006, every one of the Wall Street banks had record profits quarter after quarter, which had the illusion of a good economy and a strong finance sector. Now, not only do we know that was entirely illusory, all those profits and much, much more have vanished in the cost of cleaning up the financial crash."

But Wayne Abernathy, vice president for financial institutions policy and regulatory affairs for the American Bankers Association, worried that once the Fed raises the buffer, it might never lower it again.

"One of the most positive things that we recognize in this is that it is an admission or recognition on the part of the regulators for importance for all these prudential regulations — not just this one, but frankly all of them — to be countercyclical rather than procyclical," Abernathy said. "Having said that, though, we're skeptical about whether it's going to play out that way. Will regulators really let banks draw down their buffers, which is what I think they're suggesting would be the case?"

Then there is the question of whether the Fed will use the new buffer at all. In its proposal, the central bank set the current rate at 0%, leaving some analysts wondering if the agency will ever dare to raise it.

"We remain dubious that the Federal Reserve will impose the counter-cyclical capital buffer during times of rapid expansion, as the political pressure will be enormous to keep the party going so more people can benefit from the good times," said Jaret Seiberg, an analyst with Guggenheim Securities.

For their part, Wall Street reform advocates are hopeful the Fed will act — and will maintain the capital buffer throughout the business cycle, both the downward period of the cycle in addition to its upward swing. They also want to ensure that the buffer is composed of quality assets rather than risk-weighted assets, the value of which is not always as steady as it may seem.

"It's not just the perceived quantity of capital, but that it's the actual quantity and quality of capital," said Kelleher. "One of the problems is when there's a capital rule or proposed rule or discussion, the banks want to talk about risk-weighted capital, which they talk about as if it's real. Of course the nominal amount of risk-weighted capital is usually significantly higher than actual capital available when needed."

Another concern from the reform crowd is that the Fed plan may not look deep enough for systemic problems. As drafted, the proposal looks generally at the economy, but Marcus Stanley, policy director for Americans for Financial Reform, said the central bank should be more specific by identifying assets or markets that may be heating up. The final rule should examine those markets and be able to assign the capital buffer to banks based on their exposure to them, he said.

Some also worry whether 2.5% is a high enough charge to be a deterrent.

"Nobody would have avoided investing in subprime mortgage securities just because they had to hold 2.5% of extra capital overall," Stanley said. "The relative reward of those still would have been very attractive. An 2.5% extra capital wouldn't have shielded you from the fallout had you invested in them."

Some industry observers are also concerned that the entire concept behind the countercyclical buffer is relatively untested.

"The view that you can strangle procyclicality by throttling big banks is unproven, and when tested doesn't work," said Karen Shaw Petrou, managing partner of Federal Financial Analytics. "You're basic risk-based capital rule is, 'You want to lend to subprime mortgages? OK, but it will cost you more.' This is, 'You want to lend to subprime mortgages? OK, now it's going to cost you so much, we hope you won't do it.' That's the difference."

But Mike Konczal, a fellow with the Roosevelt Institute, said that the proposal was a thoughtful opening bid on how to implement the buffer in a way that both the industry and public interest groups can support. It lays out a variety of ways in which the banks can meet the buffer's requirements, all of which would improve prudential and macroprudential security.

The rule also gives the Fed the ability to do something that it couldn't quite do before — that is, to compel the largest and most interconnected banks to retain more capital relatively quickly to prepare for any storm clouds it may see on the horizon. And it does not constrain itself to one or a handful of metrics to determine whether danger is approaching, Konczal said.

"The other thing that jumps out is that they don't have a single metric, which is really good," Konczal said. "They're looking at everything from credit-default swaps to credit-to-GDP ratios. If they were to announce that there would be one metric, that could be gamed or lost or otherwise make this kind of useless. I think they're going to get blowback from the left, with people saying they're looking at too much, but I think that's a real strength of the process."