Don’t weaken the G-SIB surcharge

Throughout the Trump administration, banking regulators have systematically rolled back bank capital requirements designed to protect the U.S. financial system.

Next on the chopping block could be a capital surcharge that fortifies the country’s largest banks. Weakening this safeguard amidst the uncertain economic recovery would be dangerously shortsighted.

For big banks, “all in” capital requirements consist of four components: baseline requirements; a stress buffer; the countercyclical buffer; and the global systemically important bank — or G-SIB — surcharge.

Over the past several years, the Federal Reserve has methodically weakened the first three of these components.

Consider baseline capital requirements. In 2013, the Fed mandated that a bank maintain at least 3% common equity Tier 1 capital relative to its total exposures, consistent with the international Basel III accord. This supplementary leverage ratio, as it became known in the United States, works in tandem with risk-based capital requirements to ensure that banks maintain adequate capital cushions.

But this April, the Fed gutted the supplementary leverage ratio by temporarily excluding U.S. Treasury securities and reserves from a bank’s total exposures. The Fed’s stated purpose was to alleviate market stresses during the coronavirus crisis, but this misguided decision could reduce bank capital levels by up to $76 billion during the pandemic, putting the financial system at greater risk.

If the Fed wanted to minimize the effects of pandemic-related deposit inflows on banks’ supplemental leverage ratios, it could have provided more targeted relief. For example, it could have limited the exemption to treasuries and reserves above then-current levels. Instead, the Fed chose the bluntest tool possible — excluding all treasuries and reserves — thereby providing unjustified capital relief.

Next, there’s the stress buffer. Earlier this year the Fed adopted this new buffer to incorporate the results of its annual stress tests into banks’ point-in-time capital requirements. In general, a bank must maintain a capital buffer equal to the decline in its capital under the stress tests’ severely-adverse hypothetical scenario.

The stress buffer is sensible in theory, but the Fed’s final rule substantially weakens the underlying stress tests on which it is based. For example, the stress capital buffer rule assumes that banks pre-fund only four quarters of planned capital distributions, instead of nine quarters previously. Additionally, the final rule eliminated the proposed stress-leverage buffer — effectively removing the leverage ratio as a potential constraint in the stress tests.

Then there’s the countercyclical capital buffer. The so-called CCyB is supposed to be added onto baseline requirements when the economy is strong to give banks an extra buffer for when the market inevitably sours. The Fed, however, chose never to activate the CCyB before the coronavirus pandemic, despite a decade of strong economic growth and numerous experts urging the central bank to do so.

That brings us to the final capital component. The G-SIB surcharge is an added layer of capital that varies in size depending on a bank’s systemic importance. An individual bank’s G-SIB surcharge is calculated based on measurements of its size, interconnectedness, cross-jurisdictional activity, substitutability, complexity and use of short-term wholesale funding. Currently, eight U.S. banks are subject to G-SIB surcharges ranging between 1% and 3.5% of common equity Tier 1 capital.

The G-SIB surcharge serves two purposes. First, it ensures that the most systemically important banks maintain bigger cushions to absorb losses and thereby prevent their failure. Second, because the surcharge increases as a bank becomes more systemic, it encourages G-SIBs to proactively reduce the risks posed to the financial system in order to lower their surcharges.

Over the years, the G-SIB surcharge has worked as intended. Consider JPMorgan Chase, whose surcharge was initially set at 4.5% in 2014. In an effort to limit its capital burden, Chase simplified itself by shedding derivatives exposures and illiquid assets. As a result, Chase reduced its G-SIB surcharge to 3.5% in 2015, helping both the bank and broader financial system.

Lately, however, bank lobby groups have been urging the Fed to weaken the G-SIB surcharge as well. The groups argue that the Fed should revisit its methodology to ensure that G-SIB surcharges do not inadvertently creep up over time due to economic expansion. This lobbying campaign is likely to heat up in the second half of 2020, as coronavirus-related bank growth increases banks’ systemic risk scores.

The Fed should resist this pressure. Facing a bleak and uncertain economic recovery, now is not the time to cut capital requirements for the largest and most systemically important banks in the U.S.

Just last month, the Fed projected that several big banks would approach or breach their minimum capital levels in a double-dip recession. Accordingly, the Fed should insist that the G-SIB surcharge remain as robust as possible.

If banks’ surcharges increase this year, it would be for good reason. Collectively, the 10 largest U.S. banks grew by more than $1.2 trillion in assets in the first quarter of 2020.

Chase alone had a 20% boost in assets, becoming United States’ first $3 trillion bank. Meanwhile, the largest banks’ systemic-risk metric (SRISK) — which measures a firm’s expected capital shortfall given a severe market decline — has more than doubled since the beginning of the year.

The massive expansion of the largest U.S. banks could undermine an economic recovery if the G-SIBs do not maintain sufficient capital cushions to absorb losses.

Despite banks’ claims to the contrary, the Fed need not reduce the G-SIB surcharge to stimulate lending. Indeed, better-capitalized banks actually lend more than lower-capitalized banks. A real threat to lending would materialize, however, if one or more G-SIBs were to experience financial distress — a prospect made more likely if the Fed were to weaken the surcharge.

The Fed has eviscerated bank capital requirements over the past several years, with only the G-SIB surcharge left untouched … so far.

While each of these rollbacks in isolation is bad enough, the collective effect exposes the financial system to pronounced and unjustifiable risks. It is essential, therefore, that the Fed resist efforts to weaken the G-SIB surcharge that would further undermine the banking sector’s resilience.