WASHINGTON – A leading trade group representing some of the largest U.S. banks said Tuesday that the Federal Reserve Board's proposal on countercyclical capital buffers likely violates administrative procedure laws.

In a comment letter to the Fed, Greg Baer, president of the Clearing House Association, said the group supports the principles of enhanced capital for large banks as a way of safeguarding individual institutions as well as the financial system at large. But as proposed, Baer said, the proposal gives the Fed too much power to unilaterally require banks to hold additional reserves without any public notice or comment, which are baseline requirements for any regulatory action as required by the Administrative Procedure Act.

The letter, and challenge to the proposal on legal grounds, suggests the industry could pursue legal action over the Fed plan.

"The proposed countercyclical buffer … suffers from severe legal and conceptual problems, and its numerous and significant costs would greatly exceed any potential benefits," Baer wrote in the comment letter. "In particular, the proposal would establish a framework for future determinations about the countercyclical buffer that is procedurally deficient and conceptually flawed."

The comment letter went on to argue that any future iteration of the Fed's capital buffer plan, in addition to being re-proposed and providing the opportunity for interested parties to comment, should also "provide clearer, more specific, and empirically anchored standards" for future capital level changes – a standard that the current proposal does not meet.

Administrative case law is guided by two general principles. Under the APA, federal agencies are limited in their ability to issue binding regulations without abiding by certain administrative requirements. Those include notice and the opportunity to comment. Regulators also cannot move forward on a rule without making certain cost considerations and reasonable conclusions based on examination of all available relevant data and information. But federal courts are also highly deferential to agencies: A rule must be arbitrary, capricious, based on an empirically false or impossible set of assumptions, or have ignored contrary evidence demonstrably in the agency's possession, in order to be overturned.

The Clearing House letter appears, at least in part, to lay the foundation for a legal argument that the Fed's countercyclical buffer meets the standards for review under the APA. The letter argues that prudential capital standards are binding rules with a legislative mandate, are therefore subject to APA requirements, including notice and comment.

At issue is a guiding framework document the Fed published in December designed to inform banks about how the central bank would implement its Basel III capital standards - known as Regulation Q – which bank regulators completed in 2013. That regulation gave the Fed the discretion to set the buffer at between 0% and 2.5% of risk-weighted assets for banks with more than $250 billion of assets or more than $10 billion of on-balance-sheet foreign assets, subject to a 12 month notice period to adjust their capital (unless, the rule says, "the Board determines that a more immediate implementation is necessary based on economic conditions.")

The rule also notably says that any change to the countercyclical capital buffer will be made "in accordance with applicable law" and that the agency "expects" that any decision to adjust the buffer will be made jointly with the board, Office of the Comptroller of the Currency and Federal Deposit Insurance Corp.

The Fed issued the December framework in order to clarify what factors might go in to making such a decision, and named several metrics that may be considered, including "measures of relative credit and liquidity expansion or contraction, a variety of asset prices, funding spreads, credit condition surveys, indices based on credit default swap spreads, options implied volatility, and measures of systemic risk". The framework also said debt-to-GDP ratio and its growth, as well as the relationship of debt-to-GDP ratio and the prevailing trends in residential and commercial real estate prices, would be considered. But the framework also said that the Fed would not limit itself to specific metrics but rather would adopt additional factors for consideration if they could prove useful in anticipating changes in the credit cycle.

"No single indicator or fixed set of indicators can adequately capture all the key vulnerabilities in the U.S. economy and financial system," the framework said.

Baer said that breadth of metrics and potential future metrics leaves the methodological basis for capital increases too "open-ended" and unclear, and there seems to be little guaranteed opportunity for affected banks to look under the hood and ensure that the bank's methodology is sound. "In short," it's "anything and everything related to the economy," he said in the letter.

"The countercyclical capital buffer rules and policy statement issued by the Federal Reserve are so vague and open-ended that they do not provide a meaningful opportunity for interested parties to substantively comment on the Federal Reserve's proposed approach," Baer said in the comments. "No information is provided about the specific models, criteria, or data that the Federal Reserve intends to use … along with a clear reservation of authority to use other tools not described in the proposal."

Public interest groups generally supported the proposal when it was introduced, though some expressed concern that the 2.5% upper limit was inadequate to truly curb an overheated market such as the one the preceded the 2007-8 financial crisis.

The TCH comment letter is thus far the only public comment on the December framework the Fed is known to have received, as listed on its Freedom of Information Act site.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.