WASHINGTON — The Federal Reserve’s proposal to modify a key capital rule is generating a fierce debate among regulators about how much capital would be unleashed by the plan. And the range of estimates is uncommonly wide.

The proposal, issued last month by the Fed and the Office of the Comptroller of the Currency, would modify the so-called enhanced supplemental leverage ratio, a capital buffer that is applied only to the eight global systemically important banks based in the U.S., including JPMorgan Chase, Citigroup, Bank of America and Wells Fargo.

The Fed estimates that the plan will have little impact on overall capital levels, estimating that those eight bank holding companies would be required to hold just $400 million less capital than they currently hold. But the Federal Deposit Insurance Corp., which did not adopt a similar proposal and whose chairman has criticized the plan, seized on the Fed’s estimation that $121 billion less capital will be retained at the insured depository institutions within those holding companies

Fed’s Randal Quarles and the FDIC’s Martin Gruenberg
At odds: The Fed's Randal Quarles, left, says the capital proposal won't result in much capital impact, while the FDIC's Martin Gruenberg is worried it will heighten systemic risk. Bloomberg News

With a humongous gulf between $400 million and $121 billion, that's raised a critical question about which estimate is the better one in measuring the impact of the plan. The answer may be equally confusing: Both numbers are right but also misleading.

“There’s cases for both and cases against both,” said Isaac Boltansky, an analyst with Compass Point Research & Trading.

The difference is critical in an evolving debate that pits the FDIC against the Fed, though both numbers originate from the Fed’s proposal. On the one side, FDIC Chairman Martin Gruenberg, a Democrat, underscored the capital losses at the depository institution. That position also supported by former FDIC Chairman Sheila Bair and Vice Chairman Thomas Hoenig — a Republican and an independent, respectively — who wrote an op-ed arguing that the effect of the changes would be “make the financial system less resilient and to make another financial crisis likelier and more severe.”

On the other side is Fed Vice Chairman for Supervision Randal Quarles, a Republican, who argues that the plan won't have a drastic impact.

“Taken together, I believe these new rules will maintain the resiliency of the financial system and make our regulation simpler and more risk sensitive,” Quarles said.

Much of the difference in estimates can be traced to what the regulators are trying to measure. The FDIC is primarily concerned with the impact on the individual banks within the holding company, while the Fed is focused on the holding companies themselves rather than the individual subsidiaries.

Under current regulations, individual banks adhere to a higher 6% capital requirement, while their holding companies adhere to a 5% ratio. The proposal would lower both ratios to a single 3% baseline supplemental ratio, but add an additional buffer of 50% of the applicable G-SIB surcharge — a change that aligns with the Basel Committee’s amendments to the leverage ratio from December.

In all cases, banks’ leverage capital requirements would go down, but the capital savings at the individual banks go down the most, because they were higher to begin with — hence the $121 billion figure emphasized by the FDIC.

The Fed arrived at its $400 million estimate by considering not only those individual bank capital reductions, but also how the other applicable capital rules — specifically the risk-based capital requirements and the stress tests — would interact with those reductions. To reach those estimates, the Fed examined how the banks’ balance sheets would perform under the new proposal while keeping those other capital requirements intact. What they found was that while there would be a significant drop in capital retained at the individual bank level, those other risk-based capital constraints would essentially move the capital elsewhere within the holding company, save for about $400 million.

The problem with both numbers is that they carry with them certain assumptions and also ignore predictable countervailing behaviors. The release of $121 billion from the individual bank subsidiaries implies that that entire sum will flow out of the company in the form of dividends and share buybacks and ignores the other capital constraints that might keep capital within the holding company, which doesn't seem plausible. The $400 million figure assumes that banks would make no changes in their capital allocations in response to the rule change, which is also highly unlikely.

Boltansky said that neither number can be taken completely at face value, but said when assessing the potential impact of a change like this, the bigger figure can give you a sense of at least the potential scope of a change.

"I don’t know which one is fairer, but you normally have to go with the one that’s more impactful, so that’s IDI," he said.

Banks themselves seem to be indicating that they think the changes will release more than $400 million in capital. In an April 12 research note, Goldman Sachs said it thought the proposal would give the megabanks “greater freedom to redeploy balance sheet capacity to low-risk secured financing services” like repo transactions, sovereign bonds and cleared derivatives. But the bank also said that it might make strategic sense to increase dividends and buy back stock instead.

“Even after these rules change, the return uplift from reinvesting in repos and derivatives could remain lower than simply returning the capital in the form of dividends and buybacks in many cases,” the Goldman note said.

But the note also said that the other capital constraints on G-SIBs — including the additional scrutiny the Fed places on short-term wholesale funding when calculating the G-SIB surcharge — could force banks to think long and hard about how to redeploy their assets.

“The G-SIB capital methodology still incorporates both size and complexity, which we think could be a limiting factor when banks consider the optimal size of their total balance sheet and interconnectivity,” the Goldman note said.

Marcus Stanley, policy director for Americans for Financial Reform, said that the proposal would essentially encourage banks to find assets that have the highest returns while also having the lowest risk weights, which could create artificially high concentrations in certain asset classes. And if risk weights are wrong, the consequences would be dire.

“The reason the leverage ratio exists is because regulators blew it on their risk-based capital ratios in a huge way before the crisis,” Stanley said. “The regulators are basically saying, ‘Trust us on our risk-based capital ratios, we’ve got it right.’ ”

Michael Konczal, a fellow with the Roosevelt Institute, said the potential risks of lowering the supplemental leverage ratio likely outweigh the risks of having the leverage ratio serve as banks’ binding constraint. In the latter case, banks might be tempted to enter into riskier activities in order to grow, he said, but reducing banks’ ability to weather shocks regardless of where they might originate could invite catastrophe.

“I have not heard a strong enough case for me to be very worried for our financial system if the leverage ratio is high enough to be binding instead of the risk-weighted" ratio, Konczal said. “The way you fix that is either to raise more equity or adjust the risk weights, it’s not to weaken the leverage requirements.”

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