Why regulators need to take another look at bank capital

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In the 10 years since the financial crisis, regulators and banks have made many changes to strengthen the financial system. There’s perhaps no bigger change than the significant increase in the amount of capital banks of all sizes now hold as an insurance policy against losses.

We agree that these higher capital levels have helped to make the system safer, but asking banks to hold too much capital, the wrong kind or making the calculation methodology too complex can also have negative repercussions for consumers and the broader economy.

Now is the right moment for regulators to get bank capital levels right, so banks can fully support the communities they serve, without compromising the safety and soundness improvements over the last 10 years. We’re pleased to see regulators asking the right questions, namely, “Are there ways to make improvements?”

Banks finance their operations in a number of ways, but capital is fundamental. Before gathering deposits and taking on debt comes capital. Because of the risk to investors, it is also the most expensive.

Capital stands as a wall between those who lend to banks and a loss on their investment. But only the earnings left after paying depositors, creditors and everyone else — the profits — go to the capital investors. Too much capital, and those profits can be spread very thin, discouraging existing capital backers and making it hard to get new ones. Too little capital, and creditors become nervous. So do regulators.

That’s why adequate amounts of high quality capital are a shared interest of bank management and bank supervisors. The very appropriate question that bankers and regulators are asking is, “Does it really take thousands of pages of regulation and guidance to give life to that basic principle?” Earlier this year, when Federal Reserve Vice Chairman for Supervision Randal Quarles counted 24 different capital and other loss absorbing requirements, he concluded, “I am reasonably certain that 24 is too many.”

Quarles noted that “it is inevitable that we will be able to improve” the prudential regulations of recent years, “especially with the benefit of experience and hindsight.” That process is ongoing, in a careful, considered and measured way. The exercise is not one of a regulatory pendulum swinging one way or another, but rather a national effort to get the rules right. We need to support that work.

A year ago, all three bank regulators proposed as an early step simplifying capital rules that focuses on mortgage servicing assets, deferred tax assets and investments in trust-preferred securities, among others. In the comment period, very few objections were raised to the simplification proposal. The remaining step is to finalize that reform rule.

Congress is also engaged. The recent regulatory relief act passed this spring moved to reduce complexity in the capital treatment of certain commercial real estate assets.

In that same legislation, Congress put its seal on a concept raised in 2014 by the American Bankers Association and bankers associations from every state and Puerto Rico. Section 201 directs regulators to deem community banks that have 8% or more of capital to be in compliance with the overly complicated Basel 3 capital rules without having to work through those Basel complexities. This is simple common sense that will allow well-capitalized community banks to focus on lending and not international compliance regimes designed for more complex institutions.

In another proposal, the regulators seek to unite stress testing and capital requirements for all larger banks. The new concept of a stress capital buffer is an excellent example of tailoring. Tailoring of regulation, widely embraced by policymakers, was made statutory in the recent reform legislation. With the capital buffer, each bank of significant size would be tested against plausible near future risks, yielding a specific calculation of buffer capital for that bank to carry until the results of its next stress test. This is a capital reform structure that merits public support.

Regarding capital reform for the largest banks, regulators aim to reinforce the interaction of the dual concepts of risk-based capital measures and the backstop value of leverage capital. Under current rules, leverage capital can be applied in such a way as to render risk-based evaluations completely irrelevant for some banks. Risk-based models, which regulators have been refining for years, are far from perfect, but leverage capital (which ignores risk entirely) is by design and definition imperfect. Appropriately taken together, however, the two can buttress each other, offsetting the weakness of each approach.

From the big-picture view, these and other regulatory reform efforts mean a fabric of work to get the rules right. Removing unnecessary complexity, improving tailoring and strengthening the interplay of capital standards requires detailed, meticulous labor for all levels of the industry, but should result in more efficient employment of bank capital. It also means more useful capital measurement that will improve bank supervision and also be of greater value to those who manage their institutions. Those are goals that merit our encouragement.

By building off the improvements made since the crisis, we can have a capital regime that fosters the stability we all want, while reinforcing the economic growth and investment we all need.

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