The debate about the safety and soundness of the U.S. banking system has lately focused largely on one indicator of a bank’s health: capital.

Capital does play a fundamentally critical defensive role as a loss-absorption buffer during periods of stress. A key lesson from the crisis is how unsafe a dearth of capital can prove to be. So it should not be surprising that policymakers have focused on capital adequacy in a variety of pending and already-enacted policies — from the heightened capital threshold in Rep. Jeb Hensarling’s Financial Choice Act, to the “total loss-absorbing capacity” rules, to the bevy of stress tests performed in the years since the crisis.

Capital requirements have continued to dominate the post-crisis discussion as part of a common objective to defeat “too big to fail.” But that debate tends to leave out all the other factors examiners use to gauge institution strength, therefore sidestepping a holistic approach to safety and soundness regulation.

Wachovia branch
Capital is not the only reason for bank failures; at times it is not even the primary reason. Wachovia, which would have failed if not acquired by Wells Fargo, fell victim to a traditional run on the bank. Bloomberg News

Capital is not the only reason for bank failures; at times it is not even the primary reason. Wachovia, one of the largest banks supervised by my former employer, the Office of the Comptroller of the Currency, came close to failure before being rescued by Wells Fargo. However, Wachovia appeared to be a liquidity failure, a traditional run on the bank, and not due primarily to deficiencies in capital. Wachovia is a good reminder that lack of liquidity is typically the primary driver of large bank failures.

U.S. regulators implementing a post-crisis regime — which includes the Dodd-Frank and revised Basel standards — have opted for “super-equivalent” capital and liquidity requirements, resulting in U.S. banks holding historically high amounts of both. Yet many regulators, academics and lawmakers continue to recommend even higher requirements, just as the new administration is embarking on policies promoting more robust economic growth and a reduction in regulatory constraints.

Are standards too lax or overly restrictive? Will any relaxing of capital standards put the banking sector in jeopardy or compromise all of the progress made since the last crisis? Any policy prescriptions need to be empirically based, and any such analysis will require that policymakers broaden their perspective so as not to be singularly focused on capital. A more holistic view is needed that considers the cumulative impact of changes to bank balance sheets and business models that have occurred post-crisis. Such a view may allow us to look at capital as an offensive tool, supporting economic growth, not simply as a defensive measure.

As noted by the Wachovia example, capital is but one element in a strong balance sheet. Liquidity or access to stable funding may be more important than capital if history has taught us anything. Banks with strong liquidity are able to endure shocks to earnings and capital without risk of a run on the bank. Strong liquidity allows banks to survive market disruption and benefit from the eventual recovery in asset values as investor panic subsides. It is why the primary tool during periods of stress for central banks such as the Federal Reserve is to add liquidity to the system. This allows time for the healing process to occur and helps mitigate the impact of mass liquidation of distressed assets.

A comprehensive approach to assessing “too big to fail” risk would incorporate other loss-absorbing capacity from earnings and loan-loss reserves as well as liquidity and not focus solely on capital. Such a universal approach has been the basis for bank examiner assessments of safety and soundness for decades, but it has somehow gotten lost in the ongoing, capital-centric policy debate.

In the years since the crisis, policies implemented by Congress, the regulators, and by banks on their own, have undoubtedly resulted in a stronger system. As of November 2015, the 19 largest banks supervised by the OCC had increased their aggregate capital, core funding, liquid assets and long term debt by over $5 trillion, on top of a $10 trillion base. In addition, the allowance for loan loss reserves at that time were much higher as a percentage of loans than in 2007, and are slated to go higher with the implementation of new accounting standards. The aggregate impact of regulation has resulted in a dramatic improvement that begs the question, “Might we wish to see how this turns out prior to adding more requirements?”

On both an absolute basis, and compared with other countries, the largest banks in the U.S. have improved their aggregate balance sheet strength beyond question.

Concurrently, banks have also taken measures to simplify their balance sheets and reduce risks that proved most damaging in the last crisis. Bank holding companies of OCC-supervised banks have shed approximately $1 trillion (33%) of nonbank assets, which has simplified complex organization structures and reduced risk. Improvements in industry results for Dodd-Frank Act Stress Tests (DFAST) performed by the OCC and Comprehensive Capital Analysis and Review (CCAR) tests conducted by the Fed reinforce stronger risk management practices. Finally, the Federal Deposit Insurance Corp.’s resolution authority has resulted in a much clearer pathway to unwind a large, systemically important entity.

Is there an opportunity for these stronger, well-capitalized banks with more stable funding and lower risk profiles to play offense in supporting more robust economic growth?

I believe such an opportunity exists on the margin without jeopardizing the cumulative progress that has been made under Dodd-Frank and Basel initiatives. With liquidity and core funding at record levels and more rigorous reserves for loan losses in process of being implemented, a better balance can be struck.

We should suspend further actions that would increase capital requirements beyond current levels and be willing to consider additional adjustments in the future. It would be prudent to learn from our next stress event prior to making any material changes to reduce capital requirements. However, a comprehensive view of the transformation of the U.S. banking system would suggest that there is ample strength to mitigate “too big to fail" risk while supporting further growth in the U.S. and global economies.

Martin Pfinsgraff

Martin Pfinsgraff

Martin Pfinsgraff is former senior deputy comptroller for large-bank supervision at the Office of the Comptroller of the Currency. He is the founder and executive director of MP Alpha Advisory.

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