A year ago, Federal Reserve Vice Chairman for Supervision Randal Quarles offered up an important finding from Fed research. He tallied 24 “loss absorbency constraints” — such as bank capital — placed on banks. He said he did not know “the socially optimal number,” but was “reasonably certain that 24 is too many.”
The vice chairman was not alone in that view. Richard J. Herring, a professor at the Wharton School,
The layering of additional capital requirements creates a complexity that at best provides the same information in differing ways. At worst, it can too often obscure the most important data for regulators and bank management alike.
Fortunately, reforms are underway that will affect banks across the range of size and business models. For instance, proposed reforms to the enhanced supplementary leverage ratio (a risk-blind way of measuring capital) will ensure that it complements, but does not replace, risk-weighted standards. While each method has weaknesses, both taken together can help offset shortcomings. Reinforcing but not duplicating those standards, a new stress capital buffer would replace various stress testing programs with an approach that ties countercyclical stress tests and capital standards more closely together within regular ongoing bank supervision.
Tailoring capital expectations and other prudential regulations applied to the variety of large banks — implementing the 2018 reform law — will ensure that supervisory jackets better fit differing bank risks. Relieving highly capitalized community banks from complex Basel capital calculations, another congressional mandate from last year, recognizes that Basel III standards were never a good fit for community banks.
These efforts are not focused on the amount of capital held, but rather on how capital standards can be more closely adapted to risk. Acknowledging the surfeit of capital standards is only a starting point. The layering of capital standards was an iterative process applied over several decades. Reform does not need to take that long, but it does require care and may also best involve a dynamic effort made in various steps.
Herring guides us to the right consideration to pilot that work when he notes that “market participants will understandably want to know which of the ratios is most important.” That is to say, we do not need to ask whether this or that capital measure has value. Every regulatory iota seems to have its advocate. The more fruitful question is, which few will tell us the most? That may be answered by finding out which measures of capital are the ones that regulators, bank management and investors actually use. I doubt that they keep a fixed eye on all 39. Herring has the temerity to suggest that we might be able to do without 35 of them, remarking that Fed stress testing only looks at four.
As Herring asks, “what would it take to exorcise” the complexity “demon from the U.S. financial regulatory system?” How the banking regulators handle their current reform projects may offer an answer.
In 2010, the world was awash in proposals to address financial risks, many of which have since been adopted, whether at Basel or by Washington. At the time, Howard Davies, then director of the London School of Economics, cautioned that “we could move into an environment of reckless prudence.”
It would be prudent now to look at what regulation has wrought and to ask what is working and what needs to be adjusted to work better. That is work worth doing.
