Fed Gov. Quarles is wrong about bank capital buffers

In a speech to Wall Street lobbyists on June 3, Federal Reserve Vice Chair for Supervision Randal Quarles touted what he views as his most significant policy accomplishments during his tenure. Among the achievements Quarles highlighted was the Fed’s decision not to activate the countercyclical capital buffer (CCyB) — a discretionary cushion of loss-absorbing capital — in the lead-up to the COVID-19 crisis.

Quarles’ views about the CCyB, however, rest on a misleading narrative. When considered in the appropriate context, the Fed’s decision not to use the CCyB in the lead-up to the pandemic was deeply flawed, and Quarles’ revisionist history could threaten the nascent economic recovery if emerging financial stability risks go unchecked.

The Fed established the CCyB in 2013 as an extra capital buffer it could require the largest banks to maintain “when systemic vulnerabilities are meaningfully above normal.” In such circumstances, requiring banks to accumulate an extra capital buffer could slow the growth of credit bubbles and prevent the economy from overheating while, at the same time, increasing the resilience of the banking system to a potential downturn.

During the historically long economic expansion of the 2010s, numerous economists and policymakers, including former Fed Chair Janet Yellen, urged the central bank to activate the CCyB in light of escalating risks. Meanwhile, many other developed countries — including France, Germany and Hong Kong — increased their countercyclical buffers.

Despite this pressure, however, the Fed consistently declined to activate the CCyB, voting annually to maintain the buffer at 0%. In 2019, Gov. Lael Brainard dissented, asserting that escalating financial stability risks necessitated raising the CCyB.

Two years and one pandemic later, Vice Chair Quarles now insists that calls to activate the CCyB were “mistaken” and that the Fed was correct not to turn on the buffer. He maintains that the U.S. banking system performed well during the pandemic even without the additional capital cushion and that activating the CCyB pre-pandemic could have impaired lending.

Quarles’ conclusions, however, are misguided for five reasons.

First, Quarles’ claim that U.S. banks thrived during the crisis overlooks the unprecedented government support that boosted the economy and the financial system. At the onset of the pandemic, Congress and the Federal Reserve injected trillions of dollars of fiscal and monetary stimulus that shielded households, companies, municipalities, and ultimately, banks from more severe financial stress. It is disingenuous for Quarles to conclude that the banking system performed well during the pandemic without acknowledging the central role government support played in bolstering banks.

Second, Quarles wrongly asserts that the Fed did not need to activate the CCyB because the United States’ baseline capital requirements “have been set so high” that “our CCyB is effectively already ‘on.’ ” This is revisionist history. When the Fed established its CCyB framework in 2016 — with the support of now-Chair Jerome Powell — it explicitly envisioned the CCyB as an extra capital buffer on top of its minimum capital requirements, not as a cushion somehow covertly embedded in existing capital rules.

Third, Quarles’ disavowal of the CCyB in favor of “high and hard” through-the-cycle capital requirements — a sentiment echoed by Chair Powell in January — ignores the Fed’s congressional mandate. The Dodd-Frank Act directed the Fed to make capital requirements countercyclical so that banks’ capital buffers expand during times of economic expansion and decline in times of economic contraction. Countercyclical capital requirements are not just good policy — they are the law. Quarles and Powell are wrong to ignore Congress’s instructions.

Fourth, Quarles downplays the fact that an active CCyB could have served as a useful release valve to safely relax capital requirements at the onset of the pandemic. Recall that in April 2020, the banking agencies excluded cash and Treasuries from the supplemental leverage ratio (SLR), insisting this change was necessary to ensure banks could continue lending during stress. In practice, this carve-out permitted the largest bank holding companies to reduce their capital levels by up to $76 billion below levels previously deemed safe. Had the Fed turned on the CCyB before the pandemic — as many other central banks did — the U.S. could have deactivated the buffer when the pandemic hit in lieu of weakening the SLR and other elements of the capital framework.

Finally, Quarles misleadingly claims that other countries that activated their countercyclical buffers did not have higher loan growth during the pandemic than the United States. Focusing narrowly on lending outcomes, however, ignores one of the central purposes of the CCyB: to absorb potential losses on bank balance sheets. While significant losses fortunately did not materialize in 2020 — thanks, in large part, to robust government support — they could in a future crisis. Dismissing the CCyB, therefore, would be dangerously shortsighted.

Rather than casting aside the CCyB, the Fed should strengthen the buffer and ensure that future policymakers cannot ignore it as Quarles has done. As an initial step, the Fed should set the CCyB to adjust automatically based on predetermined financial stability metrics, such as the credit-to-GDP ratio, asset valuations, real-estate prices, and financial leverage. Automating the CCyB in this way would guard against future policymakers’ unwillingness to use this important tool. Similarly, the Fed should complement the risk-weighted CCyB with a countercyclical leverage buffer to further protect against boom-and-bust economic cycles.

At a minimum, however, the Fed must restate its commitment to activating the CCyB when risks are meaningfully above normal. With cryptocurrencies, meme stocks, SPACs, housing prices and nonbank leverage pointing to frothiness in financial markets, now would be a good time to revive the CCyB. Quarles’ successor as vice chair would be wise to consider activating it.