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CHANA SCHOENBERGER: Banks and regulators are often at odds, so it's no surprise that they're currently fighting over new bank capital rules. Ebrima Santos Sanneh, who covers the FDIC, OCC, and bank regulation for American Banker, had a question: why do both banks and regulators seem to think they are on the side of the little guy? I'm Chana Schoenberger, editor-in-chief of American Banker, and this is Bankshot.
AARON KLEIN: It was Sunday night. I'd gone out to dinner with my nephew and I came home and turned on the football game to see how my fantasy team was doing.
EBRIMA SANTOS SANNEH: This is Aaron Klein.
I'm Aaron Klein, Miriam K. Carliner's Chair and Senior Fellow in economic studies at the Brookings Institution. Before joining the Brookings Institution, I was Deputy Assistant Secretary of the Treasury under President Obama and chief economist of the Senate Banking Housing and Urban Affairs Committee under Chairman Chris Dodd and Paul Sarbanes. So I tuned it on late in the game and was only mildly paying attention to the game looking at my phone when all of a sudden …
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KLEIN: I looked up and was stunned to find this important, but generally obscure topic on national television in the middle of a Sunday night football game. So I happened to tweet about how insane I thought that was — work and life colliding — which caught the attention of a reporter, and the story kind of snowballed from there. For the record, I did win my fantasy game, although not the league this year.
SANNEH: The topic he's referring to is the so-called Basel III endgame, a set of regulatory proposals that came out last year and that banks have opposed more intensely than almost any other regulatory action in recent memory.
Since their emergence in the wake of the 2008 financial crisis, the Basel III accords have served as an important set of minimum regulatory standards that signatory countries — which includes most of the developed economies in the world — have agreed to observe. Most of the biggest features of the accords have been implemented in fits and starts over the last 15 years or so, but the minimum standards for operational, liquidity and credit risk remained incomplete in the U.S. — that is, until last July, when the Federal Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corp. issued a proposal that would raise capital requirements for the largest and most systemically risky banks considerably.
The question of how much capital a bank must hold to ensure its solvency without keeping it from making loans is not empirically knowable — it's a judgment, and different regulators across different administrations have reached different conclusions about what that number should be at different times. But the Basel III endgame proposal has reanimated this debate in a new way: Pitting the populist interest of ensuring that we never have another 2008 financial crisis against the populist interest of ensuring that consumer lending is plentiful and consumer prices are reasonable. But how real are those risks, and why is bank capital being framed in such populist terms?
From American Banker, I'm Ebrima Santos Sanneh, and this is Bankshot, a podcast about banks, finance and the world we live in.
SANNEH: Bank capital is hardly a kitchen table issue — most people can live their entire lives without knowing what it is or how it works. So I asked an expert to explain it.
PETER CONTI-BROWN: I'm Peter Conti-Brown, I'm an associate professor of financial regulation at the Wharton School of the University of Pennsylvania. And here I do research on banking, central banking, banking supervision, financial history, and related topics. In the jargon of banking, bank capital can refer to a variety of different things, but its central purpose is to speak to balance sheet regulation, and this bank capital is bank equity capital. You add up all its assets and subtract out all its liabilities then that's the shareholder capitalization. At the highest and broadest sense that's bank capital, it's trying to understand exactly how this was funded, how banks are funded.
SANNEH: Put another way — and, again, in the broadest terms — bank equity capital is what is left over if you subtract its liabilities — think deposits, money the bank is borrowing from you and me — from its assets, namely the loans that generate the bank's revenue. And in the United States banks have to have more assets than liabilities — and not only that, banks have to have certain kinds of assets and liabilities.
CONTI-BROWN: The reason this is so important is because bank debt we generally think of as easy come, easy go. It's relatively easy for banks — if they're willing to pay for it — to get liabilities, whether that's from depositors lending money to banks by opening bank accounts, or by, you know, issuing debt into the capital markets. There the legal obligations associated with bank debt are relatively easy to come by because they're relatively easy to redeem. And different kinds of debts are going to be treated differently, of course, but that's the basic philosophy. And that's the easy come part makes good sense, so easy go is the part that regulators really worry about. If all of a sudden you have all of the debt of a bank rapidly departing that institution, then that's a quick trip from a liquidity crunch to a solvency crisis to a failed bank, and you add up a few failed banks and all of a sudden we've got a financial crisis on our hands.
SANNEH: And this broad concept of bank capital is not a new idea.
CONTI-BROWN: Capital requirements long predates Basel and goes back to Alexander Hamilton — even before that — I mean, the basic principles and philosophies of fractional reserve banking speak to the general realization that having a well capitalized bank means that it can engage in the business of banking, well enough to survive.
SIMON JOHNSON: The long history of bank capital is very interesting, and begins with no capital regulation. My name is Simon Johnson. I'm a professor at MIT in the Sloan School of Management. I'm also the co-chair of the CFA Institute's systemic risk council. And I was previously the chief economist at the International Monetary Fund. You just say: Look, let the banks decide for themselves and in fact, a lot of banks had 50% — five-zero percent — capital, a huge amount of equity relative to the balance sheet because there was no — you go back to the 19th century — there was no safety net. With the creation of the Federal Reserve in 1913, and particularly the advent of deposit insurance in the 1930s, you've got these very important backstops. And you know, we can argue about the value of the backstop and when the backstop is manifest and whether any of the insiders face costs but there is a backstop, and that means that the costs of a bank failure — if it does fail — will be borne by somebody else — could be people who pay who stay in business and pay fees into the Deposit Insurance Fund, for example, or it could be spread more broadly onto the taxpayer through various mechanisms. So in that world, and that's the world that we live in, in the world that everyone in the industrialized democracies has lived in since the 1930s and 1940s. And that world view is that banks should be required to have these buffers of capital, so if they suffer some losses, it doesn't immediately become a solvency crisis, it doesn't get pushed over to deposit insurance or the central bank.
SANNEH: The capital definition we've just described is what is known as a leverage ratio: It's an equation where debt divided by assets equals capital, and regulators use it as a binding capital constraint. But the problem with a leverage ratio is that it treats all assets and debts the same, when in reality some loans are riskier than others and some funding sources are riskier than others: Holding a Treasury bond yielding 3% interest has less risk than a loan to build a sulfur mine in the Amazon rainforest that might bear 11% interest. rBut if all assets are treated the same, banks will naturally gravitate toward more higher-yielding and therefore riskier assets. To account for the inherent risks or absence of risk associated with certain assets, banking supervisors all over the world have adopted risk-weighted capital standards that require more or less capital to be allocated to offset losses, and in 1987 the Basel Committee on Banking Supervision — an international consortium of banking regulators based in Switzerland — came up with the first set of international standards for how risk-based capital ought to be applied, later revised in 2005 as Basel II. But risk weighting brings its own set of challenges.
KLEIN: The problem is the models are always wrong. Subprime mortgages: Not risky if diversified, geographically. Investing in your low-percentage-rate treasuries: Not risky if you're SVB. You know, the people that are in love with risk-based models are in love with the models and aren't critical and don't acknowledge the models fail, and the people that love simple leverage don't acknowledge the adverse consequences of that. In an American Banker BankThink piece I analogize it to eating with chopsticks: If you have two chopsticks, you can eat elegantly, and if you have one, you're just stabbing at it. If you're really comfortable with a dual capital system then at some points in the business cycle, simple leverage will bind and in other points risk will bind. But what we found in my 20 plus years, is people have decided who are in camp one, get mad when the other camp's is the binding constraint.
JOHNSON: That is a many-decades conversation. And the way that ended up actually before the financial crisis of 2008 is quite interesting and instructive. The Europeans had rather bought into the idea that the banks were sophisticated, clever, they had very smart models and some of the European banks, right up right in 2007 2008 had only 2% capital or 2% equity 98% debt on the liability side. And these banks were obviously in massive trouble. That was the Basel II framework — the U.S. had dragged its feet about adopting that because, in particular, the FDIC led by Sheila Bair was not convinced the banks were so very smart and not convinced that the way risk weights were proposed to Basel II was a good idea. So the US had not fully adopted Basel II. And in retrospect, that's a good thing, because U.S. banks consequently had higher capital, less leverage, more equity relative to debt. These are all the different ways of saying the same thing. And that was helpful when really bad things happened in 2008, particularly in the fall of 2008, early 2009.
SANNEH: The 2008 financial crisis brought the shortcomings of over-reliance on risk weighting home in stark relief, and the Basel Committee quickly developed another set of standards known as Basel III. And at that time, regulators were highly incentivized to come up with something that could credibly ensure that another calamity on the scale of 2008 wouldn't happen again.
JOHNSON After 2008 first was a global thing, which was that the bank regulators everywhere, including the United States realized that the people running these banks, including very large banks, the largest banks, Citigroup, Bank of America, they were all in trouble — the largest UK banks and the larger European banks as well. The view was that you know, these banks and the people around them are not actually the Masters of the Universe, they've made some pretty straightforward mistakes. They make mistakes because of the incentives that they face. It's not because they're bad and evil people necessarily, but just because they have an incentive to take a lot of risk and to have small amounts of equity, relatively large amounts of debt. So there was a big shift in the thinking of regulators and everyone in that regulatory community.
CONTI-BROWN: The Obama administration had a slightly different context because the banks could no longer argue that they were well capitalized. It's like, 2008 financial crisis: QED, the bank system was inadequately capitalized. I've seen no serious person, including from inside the banks, argue that wasn't so — nor could you. The banks failed at such a spectacular rate because they were insufficiently capitalized. And so during the Obama administration, you certainly saw the implementation of stiffer capital requirements that had preceded it. That was in part because the capital requirements that came out of Basel II had so few constraints to them.
SANNEH: Of the issues that Basel III intended to tackle was the treatment of certain kinds of risks — namely operational, credit and market risk — and what kinds of models may be used to establish those risk weightings. But whereas much of the Basel III accords have been implemented, those final elements remained incomplete.
CONTI-BROWN: And so it was through the end of the Obama administration, where the Fed started for the first time asking the question, like, you know, did we go too far? Is there too much constraint on banks? We had a relatively anemic economic recovery and our people who wondered whether financial regulation had something to do with this, including some Obama appointees. When President Trump was inaugurated and started making appointments in these key positions, one of the most important, probably the most important that he made was Randy Quarles — as the first vice chair for supervision of the Fed. He came in, I think, ideologically disposed to the idea that we had over capitalized the system and that we needed to remove some of those constraints. And his view is buoyed by the passage of a major piece of legislation, the first piece of banking legislation that followed the passage of Dodd Frank, and that was so-called Senate Bill S.2155. And that also approached capital in the same sort of way it asked the bank regulators to tailor capital requirements, among others. And so they did. One of the reasons that we're still talking about Basel III, despite the fact that we're 13 years after its passage, is because basically, during the Trump administration, the final implementation of the rules was mostly postponed.
SANNEH: When President Biden was inaugurated and Michael Barr confirmed as the Federal Reserve Vice Chair of Supervision, it was apparent that that postponement was at an end. But the collapse of Silicon Valley Bank, Signature Bank and First Republic last year created the conditions for regulators to go big — and they did. Enter Basel III: Endgame, after this quick break.
SANNEH: Last year, The Fed, FDIC and OCC issued a proposed rule to satisfy those final aspects of the Basel III accords, which the regulators themselves have dubbed Basel III: Endgame. The proposal is actually a couple of different proposals, but the ones we're concerned with would replace banks' own risk weighting models with one devised by the regulators. That model would also account for available-for-sale securities in calculating capital and expand the applicability of the supplemental leverage ratio and countercyclical capital buffer and increase capital retention for certain activities. It's a big rule that does a lot of things, but the upshot is that the biggest banks, by the regulators' own estimation, would see their risk-weighted capital requirements go up by about 16%. And banks — many of which estimate the costs of the rule as far higher than the regulators — have decided not to take this lying down, as evidenced by the football ads we discussed earlier.
MARK CALABRIA: I have, certainly throughout much of my career, been very critical of the Basel framework, and you know, I believe the Basel framework was a contributor to the problems in 2008. And while there have been modest improvements, I'm certainly of the view that the status quo is not good. So and so I'm at first, very sympathetic to what I think the Vice Chair Barr and the Fed and as well as the other regulators, FDIC and others are trying to achieve.
SANNEH: That's Mark Calabria.
CALABRIA: Mark Calabria, currently a senior advisor at the Cato Institute, which of course is a nonprofit nonpartisan think tank here in Washington, DC. I do economic strategy at the Cato Institute. Prior to that I was director of the Federal Housing Finance Agency. Prior to that was chief economist for Vice President Pence at the White House. I don't think our system is solid and sound and where it needs to be. I don't think — contrary to some of my friends in industry — I don't think banks are over capitalized. And in fact, I think most of the banking system is still highly leveraged. So, for starters, I'm pretty sympathetic to the argument for revisiting Basel, and obviously, there were pretty severe problems. You know, if our banking system cannot withstand uninsured depositors and a regional bank taking a 10% haircut — as they would have in SVB — then they're clearly problems with the system. So using that as a point of departure, obviously, it's a very long, complicated proposal. I feel like it's overly complicated. I feel like there are a number of issues with it that don't deal with the underlying problem. Certainly not the underlying problems that got Silicon Valley Bank in trouble. And I do worry that the distortions and unintended consequences will outweigh the good. So at the end of the day, I think the process has not really built a broad consensus among regulators. So to me, having looked through it, having heard a lot of commentary, even though I think that the regulators do need to revisit and update Basel, I don't think this is the right approach. I think there are elements of it that are the right approach. And I think they should go back to the drawing board, but again, I would emphasize there is a need for something like this.
SANNEH: The gist of the banks' public opposition to the Basel III endgame proposal is pretty straightforward: This rule will drive up our costs and reduce our ability to take on risk, making services more expensive and loans fewer and more expensive. That, in turn, will increase costs for consumers …
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SANNEH: But there's more to exactly how these standards might raise costs.
CONTI-BROWN: The basic idea that the banks raise, I think, comes in two flavors: The first is there's all kinds of reasons banks prefer funding themselves through debt as opposed to equity. The most common reason that they offer is that equity is expensive — they will take a pile of assets and say shareholders buy this pile of assets for $100 and the shareholder say 'no we will take that same pile of assets and pay $60 for it' — banks overvalue their assets relative to the market. That's one version of that and so they don't want to raise that money from the equity markets because that means they're not going to raise as much money. Another is that shareholders are not going to be super eager to see their own shareholdings be diluted so existing shareholders of banks are now in order to issue more equity, you're gonna have to dilute the pre existing shareholders and the all shareholders are going to look at this somewhat with a gimlet eye because they're going to say, wait we don't want to be shareholders of a an organization that's constantly diluting the value of our shareholding, so they might be more reluctant there. Another reason is because shareholders have become habituated. It's a term of use in economics. There's this habit of investing in certain asset classes and certain maturities, such as we see in banks and now it's going to be less advantageous because there's gonna be fewer dividends paid because they're having to use that money in other ways.
SANNEH: Another concern with the proposal is that lending may not go away, but instead will be forced out of banking altogether and into the arms of more lightly regulated nonbanks.
CALABRIA: There is some concern about, is this risk being pushed elsewhere, which may leave the overall system less safe? And this was a big concern. I mean, I think one of the contributors to the problems in 2008 was, there really wasn't an approach by regulators to simply say, you know, I'm only responsible for the risk of the institutions I regulate. And wherever else it goes somebody else's problem. Of course, the entire FSOC framework out of Dodd Frank is supposed to make them sit across the table from each other and think more holistically about the system. And so again, I think that's something that has been lacking in this proposal of where is this risk gonna go? And I think there's something of an underlying assumption that well, it'll just stay with banks, what will it and I think that that's an open question we need to have.
SANNEH: But those increased costs are not being imposed for no reason: The public gets something in exchange, and that is a more resilient economy whose lenders are less likely to fail when times get tough. Bank capital is an effective tool for ensuring that banks are resilient, as banks themselves evidently believed when they retained 50% capital before there was a Fed or bank regulators at all.
JOHNSON: First of all better capitalized banks don't collapse and therefore are more resilient over the business cycle — eventual cycle — so therefore, you have stronger credit over the cycle. That is point number one. Second point is in case anyone's forgotten or hasn't recently noticed, credit conditions in this country are primarily determined by the Federal Reserve. So you can either have tighter monetary policy or looser monetary policy, and if it were the case that we wouldn't be but if it were the case that bank credit were contracting in a way that was counter to what the Fed was trying to achieve at the macro level. They have considerations about output, employment and inflation, the Federal Reserve would lean the other way with monetary policy. So I, you know, I, I understand it may sound awkward for me to say this, and you know, I promise everyone I do really say this in public and to the faces of the people who make those statements, but that those claims from the banking lobby are not only completely erroneous at odds with the facts actually don't make any sense when you consider how the economy works.
KLEIN: There's a thesis among industry that, you know, higher bank capital means less profitability and there's a theory by some academics and others on the left, that kind of bank capital increases don't have any cost. I find both of them lacking critical analysis. It's hard to imagine raising capital for certain types of loans, and certain products and not others, has no cost. It's also hard to square the reality that lower capitalized banks have not been profitable on a global basis over history. European banks have often for most of the 20th century and lower capital requirements and were less profitable than American banks. And some of the most lowest capitalized banks in America were the ones more likely to fail than those with better capital.
SANNEH: This brings us to the central question, which is this: How can populism — favoring the people over elites — be on both sides of this debate over a relatively obscure regulatory proposal on bank capital?
KLEIN: There are a couple of things that are different, right, one is the capital requirements seem very large: there's a big increase in capital coming from these new rules — according to the banks — and they're happening during a period of relative economic strength. The history of financial regulation in this country is that during good times, there's deregulation, and during bad times, there's regulation. And so it's unusual for higher levels of capital regulation to occur during an economic recovery absent a banking crisis. Around Dodd-Frank there'd been a massive financial collapse. And, everybody had a moment where they acknowledged the failures of the deregulatory regime that preceded it and the need to do something different. There were legitimate questions about how far to go, what to do differently, but there was broad agreement that we needed more capital, more liquidity and broader speaking, more regulation. Now, what's different today is there has been no financial crisis, there were problems at a few banks like Silicon Valley and First Republic in the spring but that was not a systemic event, nor was that necessarily the result of inadequate levels of capital. So I think what's different here is you're seeing a new regulatory push by the bank regulators to increase capital during broadly speaking economic good times, absent a financial crisis, and you're finding an industry that is on stronger footing with the American public to say: Wait a second, we don't think this is a good idea.
JOHNSON: There has been a populist element and that was in the Trump rollback of regulations where it was claimed that this would make the banks better able to make America great again, I suppose. And it's very interesting. If you go back and look at the record of Senate hearing in 2015, in which I testified actually, on the rules for regional banks. There was a
SANNEH: The actual quote was: SVB, like our mid-sized bank peers, does not present systemic risks.
JOHNSON: Well, I think we learned that was wrong, right? It was wrong in 2015 when he said it, it was wrong in 2023 when the FDIC Treasury and the Federal Reserve invoked the so-called systemic risk exception to protect all the uninsured depositors at Silicon Valley Bank. So yes, there is a populist wave. Yes, people try to press those buttons. Underlying it is just pure straightforward greed that people running these banks want to run more leveraged institutions because they get the upside and someone else has to worry if it's when there's when there's a big downside. Lemons socialism is a term, another term for it Ebrima. So you know these people just want to line their own pockets and walk away with big amounts of money, which Mr. Becker did by the way.
CONTI-BROWN: I see in this fight a really core difference in worldview. That makes it so that those who see the issue with crystal clarity are skipping some steps and I say that to both sides. The throughline between, "The current levels protect the economy from recession and the proposed levels will take us into recession" is jagged and dotted, and I think acknowledging that you're making a bet about the future with high confidence, but low evidence is important. I think the other side, that this change in capital will prevent financial crises, or less, will go a long way to preventing more financial crises without having corresponding deleterious economic effects, that's also jagged and dotted throughlines. And appreciating that just a little — to use a word that Vice Chair bar likes to use a lot — with a little bit of regulatory humility and just that recognize that here we're looking at this not because there is any evidence that we can offer that proves our case, but because we are evaluating probabilities of different outcomes differently, that emphasizes what is truly at the core of our differences around capital regulation. That is we have just different visions about how regulation works, and how it doesn't.
CALABRIA: To me, I mean, you know, where I would sit is to say, can we come up with a regulatory system that has more capital, but lowers some of the compliance costs and tries to be simpler in a way that perhaps, you know, at least some of the industry can accept? But that said, you know, you do have a more hostile environment. I mean, it's an interesting question in that, you know, the administration's approach to, you know, SVB was to try to move past that pretty quickly. So I mean, but again, they were kind of in a box. I mean, you couldn't at the same time, try to capitalize on that without, you know, suggesting that you members of your own administration, were asleep at the wheel or, you know, our focus too much on the rescue of large tech companies that had to deposit so I think they made perhaps the right call, which was to, you know, move on from those bank failures as quickly as they could. But the cost of that was they never created a public demand to do anything else. And that's the tradeoff here. And so it is unfortunate, you know, again, I worked in the banking committee going into 2008. I can tell you try to get anybody to care about problems before they happen is very hard. There is no constituency for financial stability is the sad truth. And the pressures are always going to be, you know, to kind of erode that, especially when people feel like the economy is going well. And certainly, you know, there's always short sightedness from both industry and from the regulators. But you know, there is a change in dynamic and so the industry has a stronger hand than they had in 2010, because again, the public is less concerned about banking issues right now.
SCHOENBERGER: This episode of Bankshot was reported and written by Ebrima Santos Sanneh and edited by John Heltman. Our audio producer is Kellie Malone Yee. Special thanks to Mark Calabria of the Cato Institute, Aaron Klein of Brookings Institute, Peter Conti-Brown of the Wharton School at the University of Pennsylvania, and Simon Johnson of the MIT Sloan School of Management. For more news and analysis of the banking world, go to americanbanker.com/subscribe. From American Banker, I'm Chana Schoenberger and thanks for listening.