The Basel endgame rule could undermine US financial stability

Al Drago/Bloomberg

A major transformation is under way in the U.S. financial system, namely the growth of the nonbanks like private equity shops and hedge funds or "shadow banks" undertaking activities that traditionally occurred in the banking system. Commercial banks now originate less than half of all mortgages in the U.S. The Federal Reserve recently reported that bank loans to nonbanks surpassed $1 trillion for the first time.

What is driving this transformation? The CEO of one of the world's largest private equity firms attributed this shift to "an era of low rates and higher regulations." Numerous studies have found that increased bank regulatory and capital requirements have helped fuel the growth of nonbanks not subject to these requirements.

Since the Global Financial Crisis, I and others have expressed significant concerns about migration of bank activity to the nonbanks. As I describe in a recently published paper, I am concerned that a proposal from the U.S. banking regulatory agencies called the Basel III endgame will accelerate this migration to nonbanks that face less, if any, regulation and supervision.

This proposal would substantially raise capital requirements for the largest U.S. banks. The post-crisis regulatory regime has resulted in a significantly better capitalized banking system that is critical to support households, businesses and overall growth in both good times and times of stress.

Without question, a strong capital base provides the foundation for safety and soundness in the financial system because capital provides a cushion against losses. Federal Reserve Board Chair Powell has acknowledged, however, that it is crucial to consider the impacts of substantially higher capital on households, businesses, end users and consumers, and the unintended consequences of critical banking and capital markets activities moving to the nonbanks.

As a result of the proposal, banks may reduce their activities or withdraw from providing critical products or services as they face nonbank competitors that are not subject to these regulations. Critically, this shift to nonbanks could have the unintended consequence of diminishing the financial stability and economic resiliency and vitality of the U.S. for a number of reasons.

First, banks, compared with nonbanks, tend to stick with customers in economic distress and then provide funding through workouts and recovery. Studies have found that private firms that borrow from nonbanks are more likely to lose funding in crises and then invest less following the crisis than private firms that borrow from banks and receive funding that permits them to invest and recover. Increasing the relative size of the nonbank sector, thus, can reduce economic resiliency.

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Second, banks have been important market-makers and liquidity providers in both normal times and times of stress. If banks retreat from some of these activities or have less capacity to act as shock absorbers, markets could become less liquid and more fragile — particularly during times of stress. Markets could therefore become more volatile and "flash crashes" become more frequent, requiring more government emergency interventions.

Third, there is much less disclosure and regulation of nonbanks relative to banks. Thus, it becomes more difficult for regulators, supervisors and market participants to identify the buildup of risk concentrations and fragile interconnections and to take actions to mitigate those risks and fragilities before they crystallize into a crisis. Although increasing the transparency of nonbanks is on the policy agenda, it will be a long time before policymakers have anything close to a line of sight into the nonbank sector that they have for the banking sector.

Fourth, numerous groups submitted comments on the proposal raising concerns that their access to borrowing and banking services could be reduced or become more costly, thereby diminishing economic vitality of various parts of the U.S. economy. Latham & Watkins analyzed the official comment record and found a wide range of communities, end users and industries across the country believe they will be adversely affected by the proposed capital changes. Specifically, Latham found that over 98% of commenters disagreed in whole or in part with the rules compared to just 2% who supported them. These groups range from low- and medium-income mortgage borrowers to minority-owned businesses to green energy producers to farmers and ranchers who typically hedge their operations through banks.

Capital is a blunt regulatory instrument that has the potential for unintended consequences. The agencies provided only a very broad qualitative assessment of the proposal's costs and benefits and did not provide thorough analyses supporting their conclusions that the benefits of the proposal outweigh its costs.

Before moving ahead to finalize the rule, the agencies should first strongly consider the comment record and clarify their particular areas of concerns that they are trying to solve for. Once this is done, they should undertake a cost-benefit analysis of the proposed revisions. Otherwise, some groups could be disproportionately adversely affected, and investment and therefore economic growth could suffer. Rather than conserving supervisory resources and providing greater cushions against shocks, increasing bank capital requirements could paradoxically require greater vigilance by supervisors and generate more fragile interconnections, thereby potentially reducing the overall safety and soundness of the system.