Danger lurks in latest deregulatory push

Two weeks ago, the banking regulators, led by the Federal Reserve, issued a proposed rule that would substantially weaken certain safeguards put in place following the 2007-8 financial crisis for many of the largest banks in the country. The class of U.S. banks impacted by the various regulatory rollbacks included in the rule — those with between $100 billion and $700 billion in assets — collectively hold almost $3 trillion in assets and received nearly $60 billion in Troubled Asset Relief Program bailout funds during the last crisis. Some elements of the proposal implement provisions of S 2155, the financial deregulation bill signed into law by President Trump earlier this year, while others go even further. These changes to stress testing, capital requirements and liquidity rules would reduce the banking sector’s ability to withstand bouts of stress in the financial system, elevate the possibility of debilitating bank runs and increase the chances of another financial meltdown. This rule joins a steady stream of proposed rollbacks that, when considered together, would meaningfully erode the post-crisis regulatory framework.

The most concerning element of the proposal would lower the liquidity requirements for banks with assets of $100 billion to $700 billion. Banks with between $100 billion and $250 billion in assets currently face less-stringent liquidity requirements relative to larger banks. Under the proposed rule, however, they would no longer face two important requirements: the modified liquidity coverage ratio and modified net stable funding ratio. The LCR requires banks to hold enough liquid assets to meet their projected cash demands under stressed conditions, while the NSFR ensures that banks are better aligning their illiquid assets with more stable funding. The Fed estimates that this change would reduce the liquidity buffers at these banks by $34 billion. This change implements part of the unwise rollbacks in S 2155. But unlike S 2155, regulators didn’t stop there. They also proposed a 15%-30% reduction in the LCR and NSFR requirements for banks with between $250 billion and $700 billion in assets. This would reduce their liquidity buffers by an estimated $43 billion.

Andrew Harrer/Bloomberg

The financial crisis demonstrated the need for robust liquidity requirements. Buffers of liquid assets, which can easily be turned into cash, are crucial for mitigating the potential fire-sale risks posed when creditors head for the doors. If banks don’t have adequate liquidity buffers to meet their cash demands during a period of stress, they have to resort to damaging fire sales of illiquid assets like loans and other securities. Fire sales at these banks would transmit stress to other financial institutions with similar assets, increase costs in funding markets, and threaten the solvency of the bank itself. Moreover, creditors are more likely to pull their cash and run in the first place when they think a bank might not have the liquid assets necessary to pay them back.

The proposed rule would also allow banks with between $250 billion and $700 billion in assets to opt out of a requirement that ensures their capital levels reflect the unrealized losses and gains of certain securities. This requirement stems directly from lessons learned during the financial crisis, when bank capital levels did not necessarily reflect the mark to market losses they experienced on certain securities. This painted an unrealistically rosy picture of their loss absorbing capacity.

In addition, the Fed implemented another provision in S 2155 by proposing to reduce the frequency of stress tests for banks with $100 billion to $250 billion of assets from annually to every other year. The stress testing regime, which helps determine whether banks have enough equity capital to absorb losses during a severe economic downturn, has proved to be a powerful regulatory tool over the past decade. Earlier this year, the Fed set forth a concerning proposal to loosen certain assumptions used in the stress tests. Those adjustments would lower the required capital buffers for banks of this size. Further eroding the stress testing regime for these banks by reducing the frequency is a mistake. When analyzing this decrease in bank oversight, and other changes in the proposal, it’s important to remember that these are not small community banks. They are among the top 25 largest U.S. banks, out of more than 5,700 in the country, and the failure of one of them would constitute one of the largest bank failures in U.S. history.

Stress tests help provide creditors and the broader public a sense of confidence in the stability of the banking system. If the banking system experienced turmoil in a year that these banks were not stress tested, creditors and the public may feel that they don’t have an up-to-date picture of the banks’ health. If a bank of this size, like Countrywide, was stress tested in 2006, would creditors have trusted those results a year and a half later? This could exacerbate a panic and lead to more flighty creditors, stressing the liquidity positions of these banks. Another problem is that bank capital requirements are determined, in part, through the stress tests. Outdated projected loss figures would lead to capital requirements that don’t adequately reflect the current potential vulnerabilities of the bank’s balance sheet. Banks may also use this to their advantage by increasing their risk-taking during years in which they aren’t stress tested.

Unfortunately, regulators made it clear that more deregulatory rules are on the way. The Fed announced that new rules for large foreign banks and for living-wills requirements will be proposed in the near future.

It’s important consider the cumulative impact of these and other financial rollbacks. Trump-appointed regulators have already proposed to lower big bank leverage requirements, weaken the Volcker Rule, loosen certain stress testing assumptions and have released all systemically important nonbanks from enhanced oversight. To make matters worse, risks are currently building in the financial system as the economy moves towards the end of the economic cycle. Policymakers should be issuing proposals that build on the progress of financial reform. Instead, workers, families, savers and taxpayers will bear the burden of policymakers’ decision to move in the opposite direction.