Capital proposals a ‘win-win,’ Fed's Quarles says

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Federal Reserve Vice Chairman for Supervision Randal Quarles said Friday that proposed changes to the agency’s supplemental leverage ratio rules and stress testing regime would make the financial system safer without a material reduction in overall capital retention.

In a speech delivered at the Hoover Institution in Stanford, Calif., Friday afternoon, Quarles said that recent criticisms of the Fed’s proposals to revise the enhanced supplementary leverage ratio have centered on the assertion that the proposal would lead to heightened risk in the financial system by reducing the system’s ability to weather shocks.

The Fed and the Office of the Comptroller of the Currency issued that proposal despite the dissent of Fed Gov. Lael Brainard and without the Federal Deposit Insurance Corp.

But Quarles said the design of the plan is to eliminate the perverse incentive of banks constrained by the leverage ratio to take on riskier assets, which could potentially reduce unnecessary risks in the financial system.

“The proposed change simply restores the original intent of leverage requirements as a backstop measure to risk-based capital requirements,” Quarles said. “As we have seen, a leverage requirement that is too high favors high-risk activities and disincentivizes low-risk activities.”

He went on to say that the plan — in conjunction with another proposal to institute a stress capital buffer in the Fed’s stress testing regime — would effectively achieve those risk reductions without changing the overall capital allocation in a meaningful way. Fed analysts have concluded that those proposals would result in only a $400 million capital reduction across the eight global systemically important institutions to which the eSLR applies — an equivalent of 0.04% of those banks’ total capital levels.

“So this recalibration is a win-win: a material realignment of incentives to reduce a regulatory encouragement to take on risk at a time when we want to encourage prudent behavior without any material capital reduction or cost to the system’s resiliency,” Quarles said. “Taken together, I believe these new rules will maintain the resiliency of the financial system and make our regulation simpler and more risk sensitive.”

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