Treasury wants to weaken a crucial post-crisis capital requirement

A proposal by the Treasury Department that would allow large banks to exclude certain assets in calculating the leverage ratio is not only a misguided recommendation that would undermine post-crisis capital requirements for Wall Street. The recommendation also appears to be in direct contradiction with the leverage ratio principles outlined in the Treasury report’s own appendices.

On June 12, the Treasury released the first in a series of financial regulatory reports in accordance with an executive order signed by President Trump in February. Among the report’s worrisome recommendations is to modify the denominator in the Supplementary Leverage Ratio, or SLR. Specifically, Treasury recommends removing certain assets — cash held at central banks, U.S. Treasury securities and initial margin for centrally cleared derivatives — from what top-tier holding companies must include in maintaining a 5% SLR. This essentially makes it easier to meet the SLR requirement.

Here’s why that’s a problem.

The 2007-8 financial crisis demonstrated that the banking system was highly leveraged and severely undercapitalized. Banks were funding themselves with too much debt and too little equity capital. Responding to this lesson, the Basel Committee and Dodd-Frank Act capital regimes put an emphasis on increasing the loss-absorbing capacity of the banking sector by increasing bank capital requirements.

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The SLR is an important new capital requirement for banks over $250 billion in assets that takes into consideration all on-balance-sheet assets and off-balance-sheet exposures without any regard to the riskiness of the assets. The leverage ratio stands in contrast to risk-based capital requirements, which do treat assets differently based on their risk profile. Many academics, policymakers and regulators have discussed the importance for financial stability of having both risk-based capital and leverage requirements. They point to the fact that different assets have distinct risk profiles, but a risk-based system alone can enable banks to undercut the required thresholds.

Former Treasury Department official and current Brookings Institution fellow Aaron Klein has described this two-pronged approach to bank capital as the “chopstick” approach, saying: “One can eat Chinese food elegantly with two chopsticks. With only one you are just stabbing at your food with a stick. It is the same with bank capital regulation.”

Having only a leverage ratio would incentivize firms to load up on riskier assets because those assets offer a higher return and wouldn’t be penalized under the risk-blind leverage ratio. But only having a risk-weighted capital requirement puts too much faith in regulators and banks to appropriately calibrate the proper risk levels of different asset classes. Both together, however, complement one another and provide a balanced approach to bank capital.

But Treasury’s recommended removal of three asset classes from the SLR denominator is akin to giving those assets a 0% risk-weighting. The whole point of the leverage ratio is to avoid assigning risk-weights. Undermining that principle could limit the capital banks are required to maintain, which in turn could have serious negative consequences for the loss-absorbing capacity of banks and overall financial stability.

The odd thing about Treasury’s recommendation is that its own report appears to discuss that two-pronged approach in favorable terms, thereby undermining its own recommendation to adjust the SLR calculation.

In Appendix C, the report says: “Leverage capital requirements are not intended to adjust for real or perceived differences in the risk profile of different types of exposures. … As such, the leverage ratio requirements complement the risk-based capital requirements that are based on the composition of a firm’s exposures.”

This contradicts a major recommendation set forth in the body of the report. The recommendation to assign a 0% risk-weight to certain bank assets is the very definition of “adjust[ing] for real or perceived differences” in the riskiness of different assets.

So why does the detailed explanation of the role of leverage requirements contradict a key recommendation in the report? Perhaps the 244 banking industry organizations that consulted on the report exerted their influence. Banks with assets of more than $250 billion certainly favor this change as it would lower their capital requirements, potentially allowing them to return more capital to their shareholders through increased dividends and share buybacks. The recommended changes could lower the capital at the largest Wall Street banks by tens of billions of dollars each.

Research conducted by the Federal Reserve and International Monetary Fund (among others), however, demonstrates that current bank capital requirements are at the low end of the range of what’s considered the socially optimal level of capital — the level of capital that maximizes the economic benefits of limiting the possibility of financial crises while preserving bank lending and economic growth. If anything, this research demonstrates that the conversation should revolve around increasing capital, not lowering it.