Would raising capital requirements for a rainy day hasten one?

WASHINGTON — One Federal Reserve governor’s push to have the central bank utilize a capital buffer for large banks to counteract potential losses is sparking doubts about whether the Fed could pull off the maneuver without spooking markets.

In a speech last week, Gov. Lael Brainard said there could be “several potential advantages” to having the Fed raise the so-called countercyclical capital buffer, a Basel III-mandated tool to raise capital in boom times to offset losses from a market downturn. Her comments ran counter to more dismissive comments by other Fed officials, who have argued that conditions in the market did not justify raising the buffer.

That Brainard is raising the issue at all is giving some stakeholders cause to think that the Fed board could consider using the tool sooner or later. Yet her speech has also shined a light on the potential risks of using such a tool, particularly a concern that the Fed’s deploying the buffer could convey public concerns about risk in the system, which could trigger the type of downturn the central bank is trying to avoid.

“Good supervision should not be creating market events,” said Wayne Abernathy, executive vice president of financial institutions policy and regulatory affairs at the American Bankers Association.

In her speech at the Peterson Institute for International Economics, Brainard argued that employing the buffer — known as the CCyB — is warranted by the observable risks in the system, citing potential sources of instability in the corporate bond market and in leveraged lending. The agency should compel banks to hold more capital now while the economy is humming, she said, rather than in a less favorable environment.

“History suggests that we should not expect the market to provide incentives for banks to build the necessary buffers when times are good,” Brainard said. “One of the roles for independent regulatory bodies such as the Federal Reserve is to serve as a counterweight.”

To be sure, Brainard may only be speaking for herself. A governor since 2014, she is the lone member of the board not to get appointed by President Trump, and has been known to offer dissenting views on the board’s regulatory proposals.

But some observers said any board member raising the prospect of the Fed imposing the buffer on big banks is noteworthy.

“Whether [Brainard] is speaking for herself or not, it’s inevitably going to cause attention around the countercyclical buffer, because when a Fed governor — irrespective of who it is — is talking concretely about triggering a rule that’s on the books, it inevitably causes attention,” said Dennis Keller, president of the public interest group Better Markets. “It percolates up to the top of the agenda, both on the staff side and on the board side.”

Fed Vice Chairman for Supervision Randal Quarles seemingly cast doubt on the idea of using the buffer anytime soon during an appearance at the Brookings Institution last month. In response to a question about the CCyB, he said the agency would raise the buffer only “when we think financial stability risks are meaningfully above normal,” rather than when the Fed thinks the economy is overheating.

Similarly, Fed Chairman Jerome Powell said in June that raising the CCyB was “a possibility” but said he did not think that the financial stability risks posed at the time were “meaningfully above normal.”

Kelleher noted that Brainard’s speech isn’t necessarily at odds with Quarles’ comments — both agreed that the buffer serves a macroprudential rather than macroeconomic function. And the fact that Brainard is raising the issue suggests that it will find its way onto the Fed’s agenda sooner or later.

But Abernathy said he thought Brainard’s assessment is less likely to gain traction with the board of governors, precisely because the buffer is a capital issue and both Powell and Quarles have said they don’t think banks need to raise more capital than they already have.

“I think [Brainard] has always been in the camp that banks ought to have more capital than they currently do,” Abernathy said. “I think that’s a minority view.”

He added that the Fed has tried to move away from using regulatory tools that might move markets. Just as the countercyclical buffer could have the result of precipitating sell-offs, the public release of the Fed’s stress test results in years past has affected bank share prices — something that the central bank has sought to avoid with its proposed stress test reforms.

“Under the old [stress test] program — the current program, still — they created these market-moving events every time they announced the results of the stress tests,” Abernathy said.

The CCyB originated as part of the Basel III accords, and gives the Fed the authority to require "advanced approaches" banks — that is, banks with more than $250 billion of assets or more than $10 billion in overseas exposures — to hold additional capital when there are elevated risks of “above-normal” losses. The buffer can be up to 2.5% of risk-weighted assets.

The purpose is to have banks retain additional capital at the top of the economic cycle that they can draw on during a downturn, thus making it “countercyclical.” But that countercyclical nature of the rule creates a natural challenge for the Fed, because raising the buffer would send markets the signal that the central bank views financial risks as elevated and could potentially precipitate the instability that the buffer is designed to counteract.

Brainard herself referenced this challenge after her speech, saying that other central banks with countercyclical buffers typically avoid market disruptions by making increases gradually and telegraphing their intentions clearly and well ahead of time.

“We’ve seen a relatively large number of jurisdictions turn on their [CCyB] without any kind of market pullback or market reaction,” she said after the speech. “That has all been done in the context of well-communicated policy connected to a set of developments that are apparent from the data. I think … the framework would enable that same kind of gradual implementation, but of course continuing to maintain the clarity of framework and communicating about it will help with that market reception.”

That can be easier said than done, however. The Fed famously precipitated a spike in Treasury yields in 2013 after then-Chairman Ben Bernanke announced that the central bank would begin to slow its bond purchases — an event known as the taper tantrum. By contrast, the Fed’s initial post-recession interest rate hike, in 2015 was met with relatively mild market reaction, with analysts predicting an 80% chance of a rate increase before the meeting.

The rule implementing the CCyB calls for the Fed board to propose a buffer increase through regular notice-and-comment rulemaking, which would go a long way to ensure that the impact of the buffer would not come suddenly. But any such proposal would invariably be met with debate not only about whether a buffer is appropriate.

Christopher Whalen, chairman of Whalen Global Advisors LLC, said that when the Fed requires higher capital retention it is, in effect, artificially reducing the profitability of the banks subject to the buffer.

A less profitable bank pays out fewer dividends, which can reduce revenues by funds that invest in the banks, and ultimately can constrain markets even if that isn’t the intended effect. And the Fed could address the kinds of systemic risks Brainard highlighted with other existing supervisory powers, he said, making the buffer ultimately counterproductive and redundant.

“The first and most important indicator of default for a depository is profitability,” Whalen said. “Unless you have some weird, idiosyncratic loss, banks' capital does not, in and of itself, make the system safer. The system is safer when banks are profitable and when they have enough revenue to pay off credit losses in a given quarter and keep on going.”

The banking industry has been generally dismissive of the CCyB, with regard both to whether it should be raised and whether it should be on the books. Greg Baer, president and CEO of the Bank Policy Institute, said that the economic data wouldn’t support raising the buffer, but even if such data existed, the largest banks already are subject to various other capital buffers that render the CCyB redundant.

“The Fed’s own financial stability assessment makes clear that its standard for raising the CCyB has not been met,” Baer said. “And in any event, the CCyB is unnecessary, as the largest U.S. banks already hold three sizable capital buffers — a capital conservation buffer, a buffer under CCAR, and a GSIB surcharge — to protect against the impact of a potential economic downturn.”

Abernathy said he thinks the Fed’s proposed stress capital buffer — which would take into account each bank’s losses in the prior year’s stress test — effectively renders the CCyB obsolete. He said the stress capital buffer, when finalized, has the benefit of compelling banks to hold additional capital against losses that are at least demonstrated by internal and Fed models and reflect holdings of individual banks. The CCyB is simply applied equally across all banks.

Abernathy added that the stress capital buffer, which could be imposed on banks outside of a public forum, eliminates the challenge of how to raise the CCyB without spooking markets.

The countercyclical buffer is "a tool and they have [it] in their box … but it’s an old tool, and it’s about to be replaced by a better tool,” Abernathy said. “I think the purpose for which it was created has really been superseded by the whole stress capital buffer regime.”

Kelleher takes a different view. He noted that the countercyclical buffer is not meant to counteract specific credit losses, or even losses on an individual bank’s books, but rather to ensure that credit can continue to flow even after write-downs have spread beyond their initial source.

“Irrespective of what one thinks about how the next crash is going to happen, nobody knows,” Kelleher said. “All of the defaults of nonperforming loans are going to go up across the board. That’s what happens in a downturn. You need well-capitalized banks to absorb losses from multiple lending channels so they can lend through the cycle to those channels that are still creditworthy.”