WASHINGTON — The Dodd-Frank Act’s $50 billion threshold for determining which banks are systemically important should be scrapped and replaced with an indicator test, according to a report issued Thursday by the Office of Financial Research.
Though the message was not new – the industry has been pressing for just such a move in regulatory relief legislation being developed in the Senate – the messenger was surprising. Though an arm of the Treasury Department, the independent Office of Financial Research has generally not weighed in pending political issues, favoring a more academic approach.
But the report was unequivocal that the current standard was insufficient for determining what institutions pose a risk to the broader economy.
“Our analysis indicates that a multifactor approach could replace the $50 billion asset-size threshold that some U.S. regulations use to identify U.S. banks that are not” considered globally systemic “but warrant enhanced regulation,” wrote Richard Berner, director of the research agency, in a blogpost.
Regulators have divided firms over the $50 billion category into three tiers. Those with between $50 billion and $250 billion of assets are subject to additional requirements, including additional stress testing, the creation of resolutions plans and enhanced liquidity rules. Banks with more than $250 billion in assets are subject to even tougher standards requiring them to hold greater capital. Finally, the eight banks considered globally-systemic face more onerous regulatory requirements.
The OFR report, titled “Size Alone is Not Sufficient to Identify Systemically Important Banks,” the research agency says that the test for which banks are considered globally systemic could be applied to U.S. institutions with more than $50 billion in assets in helping to determine which institutions are truly systemically important.
In addition to a bank’s size, international regulators look at a bank’s interconnectedness, substitutability or reliance on short-term funding, complexity of business model and cross-jurisdictional activity to determine which banks are globally systemic.
Berner said adapting that test for U.S. firms would be a better gauge of which banks above $50 billion warrant higher standards.
“Such an approach could identify a much smaller group of non-G-SIB banks for enhanced prudential standards,” he wrote. “Relatively large but less-systemic U.S. institutions might no longer face regulatory costs disproportionate to their importance. Smaller banks that play unique roles in U.S. markets, are more complex, or rely on short-term wholesale funding could continue to face higher standards.”
The research agency recommends some changes to the G-SIB test. First, it wants to better account for so-called “substitutability” risks “from banks that offer unique services that are central to the functioning of financial markets.” Secondly, it wants to better incorporate the systemic importance of a foreign bank’s U.S. operations.
The report comes as the top Democrat and Republican on the Senate Banking Committee are discussing a deal to provide regulatory relief to banks. It is unclear whether that package would include an adjustment to the systemic threshold.
The House Financial Services Committee passed a bill earlier this month that would adopt the indicator test used by Basel, an international working group of financial regulators to determine which banks are globally systemic. The Federal Reserve Board uses a slightly different metric which OFR recommends along with its adjustments.
However, some lawmakers, including Sen. Elizabeth Warren, D-Mass., would prefer to leave the systemic threshold at $50 billion and allow the Fed to tailor its regulations for banks above that level.
“The proposal to replace the $50 billion threshold with a multi-factor test is no better because it relies on the Fed to proactively identify institutions that could pose economic risks,” she wrote in a Bloomberg View op-ed piece published Thursday.
But tailoring can only go so far because some requirements are mandated by Dodd-Frank.
Changing the threshold would require an act of Congress, and the OFR argues that if the regulators can determine which banks are globally systemic – a designation that is determined by the regulators rather than Dodd-Frank - they should be able to also measure which banks are systemic to the U.S.
The indicator test calculates a composite systemic score after giving each of the five measured indicators equal weights. The denominator used to calculate the different indicators is also weighted in comparison to the overall banking system. Basel tags banks with a risk-score of 130 or higher as globally systemic, which means they have to comply with an additional capital surcharge.
Using 2015 data, State Street has the lowest systemic score among the 8 G-SIBs at 148 and JP Morgan has the highest at 464. Among the rest of banks over $50 billion but not already considered globally systemic, Northern Trust has the highest score of 56, while Zions Bancorp has the lowest score at 3.
The OFR report noted that this result is in contrast to a strict criteria based on size.
“Northern Trust has assets of less than $150 billion, but a much higher systemic importance score using the G-SIB multifactor approach than Capital One, PNC, or U.S. Bancorp., each of which has assets of more than $250 billion,” said the report. “Northern Trust’s relatively high score stems from its payments activity and assets under custody.”
Since 130 is the G-SIB score, the banking regulators may decide to use a much lower score to determine which banks are considered systemically important to the U.S.
The OFR plans to update its report when 2016 data becomes available.