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Revamping Bank Regulation

Trump Proposals

T T Ram Mohan (ttr@iima.ac.in) teaches at the Indian Institute of Management, Ahmedabad.

One of Donald Trump’s big election promises was a substantial rollback of bank regulation. Trump and his Republican followers believe the regulations ushered in by the Dodd–Frank Act in the United States (US) are too onerous and too complex. They think it could render large US banks uncompetitive, make it difficult for small banks to survive and discourage innovation and risk-taking.

One of Donald Trump’s big election promises was a substantial rollback of bank regulation. Trump and his Republican followers believe the regulations ushered in by the Dodd–Frank Act in the United States (US) are too onerous and too complex. They think it could render large US banks uncompetitive, make it difficult for small banks to survive and discourage innovation and risk-taking.

Bank stocks surged following Trump’s victory on hopes that the new President would keep many of his promises. Not much has happened so far but there are indications lately of the shape of things to come. Last June, the US Treasury came out with a report co-authored by Treasury Secretary Steven Mnuchin that outlines its thinking on the subject of bank regulation (US Department of the Treasury 2017). The report argues that banks have been choked by excessive regulation since the crisis. Proof: bank lending has risen by only 25% since the crisis, far less than in previous recoveries, and gross domestic product (GDP) growth has been sluggish.

There have been many changes to bank regulation in the years since the crisis, many driven by the Basel 3 norms introduced by the Bank of International Settlements. The policy challenge for the Trump administration is to see which ones must stay, which must go, and which need modification.

Let us take a look at some key proposals in the Treasury report.

Bank Capital

The most important change in bank regulation has been the increase in capital requirements for banks mandated by Basel 3, especially the requirements of what is called tier 1 capital, which comprises equity and quasi-equity capital, in relation to risk-weighted assets. One of the reasons for bank failure in the financial crisis was said to be far too low capital requirements. Besides, the quality of capital was not good enough, that is, there was not enough equity capital. In a crisis, it is equity capital alone that gives confidence to depositors and investors. The Treasury report wisely refrains from tampering with the increase in tier 1 capital requirements mandated by Basel 3.

However, the report does propose a change in respect of another aspect of capital requirement. Basel 3 introduced a minimum supplementary leverage ratio, that is, the ratio of equity to total assets, of 3%. This translates into a debt to equity ratio of 33:1. The intention was that capital in simple accounting terms should not fall below a certain level even while a bank met the requirement of capital in relation to risk-weighted assets. In the US, regulators have stipulated a leverage ratio of 5% for large banks. Heads of large banks have been protesting loudly, saying that this puts the US’s large banks at a disadvantage with respect to international banks.

The Treasury report proposes changes in how the leverage ratio is to be calculated. This would have the effect of lowering the equity capital requirement of banks. More importantly, it makes the computation of the leverage ratio non-transparent. One objective in having the leverage ratio was to make it simple for any investor to go through a bank’s balance sheet and see if it had adequate capital. The Treasury’s proposal threatens to undermine this crucial objective.

Liquidity Coverage Ratio

Another innovation in Basel 3 was the introduction of liquidity requirements for banks for the short term (less than one year) as well as long term through a certain defined liquidity coverage ratio. This arose from the understanding that many notable bank failures (for instance, Northern Rock in United Kingdom) arose from problems on the liabilities side, not from loans going bad. The Treasury wants the liquidity coverage ratio to be confined to internationally active banks. This would certainly be a retrograde step. It would also mean that a large number of US banks would be departing from Basel 3 norms in this respect, which would undermine the international character of Basel norms.

Exemptions

The Treasury report would like community banks with assets of less than $10 billion (bn) exempted from Basel 3 norms. This should not pose a problem as small community banks can fail without affecting the system significantly. The Treasury report also wants 69 banks with assets between $10 bn and $50 bn exempted from stress tests. It asks that even the lower limit of $50 bn for the larger banks be raised but does not specify a precise number.

Bank regulators periodically carry out stress tests to see whether banks have enough capital to withstand adverse situations. Banks that fail stress tests are required to publish their results, which affects their standing in the markets. They are also sometimes required to cut back on dividends and share buy-backs in order to conserve capital. The Treasury is of the view that stress tests have had the effect of preventing regional and mid-sized banks from expanding their operations and hence limiting competition for bigger banks. There is some merit in this contention. However, changing the lower limit of $50 bn for banks to qualify for stress tests needs to be debated as it could spell higher systemic risk.

The Treasury also wants the Federal Reserve (or Fed) to subject its stress review models to public notice and comment. This is a bad idea. The Fed has argued correctly that making its models public would enable banks to game the system. For instance, banks would adjust their balance sheets at the time of having to go through the stress test and change the balance sheets thereafter.

Dilution of the Volcker Rule

The Dodd–Frank Act introduced the Volcker Rule, whereby banks were prohibited from engaging in proprietary trading and were also subject to stringent limits on investment in hedge funds and private equity. Many have argued that the Volcker Rule has hugely increased compliance costs for banks, more so for small banks. Several banks are engaged in market-making activities and they also need to hedge their positions on the banking book. It is hard to tell in practice whether securities held for banks are for proprietary trading or for other legitimate activities.

A more serious objection to the Volcker Rule is that there is no conclusive evidence that it is banks’ proprietary trading activities that render them more susceptible to failure. Some investment banks failed in the last financial crisis, others did not. Some universal banks ran into trouble, others did not. The Volcker Rule, in a sense, attempts to reverse the process of banks venturing into capital market activities. It is not clear, therefore, that the Volcker Rule is the best way to reduce fragility in banking.

The Treasury report wants banks with assets of less than $10 bn exempt from the Volcker Rule. It also recommends that the proprietary trading restrictions of the rule do not apply to banks with greater than $10 billion in assets unless they exceed a threshold amount of trading assets and liabilities. These proposals are welcome. So are proposals in the report for simplifying the definition of what constitutes proprietary trading.

Alternative Regulatory Regime

The Treasury report has also thrown its weight behind a radical proposal before the Congress under the Financial CHOICE Act, 2017. The act was passed by the US House of Representatives in June 2017 and now requires the Senate’s approval. The act gives banks a choice between the present regime, which includes Basel 3 norms and the Dodd–Frank Act and an alternative regime in which banks will have a simple leverage ratio of 10:1.

The act is attractive in that it creates incentives for banks to significantly raise their level of capital. However, exempting such banks from stress tests and other requirements could simultaneously increase incentives for risk-taking. It is worthwhile exempting banks that have a higher level ratio from the Volcker Rule, but not from the entire range of regulations envisaged in the Dodd–Frank Act. The general view is that small banks will opt for the CHOICE regime while large banks will not, as it will be a huge task for them to raise their level of capital to meet the 10:1 leverage requirement.

Capital for G-SIBs

The Basel rules include a capital surcharge for global systemically important banks (G-SIBs) in the range of 1%–2.5% of risk-weighted assets. The US had imposed stiffer norms for its own G-SIBs. As mentioned earlier, the leverage ratio for G-SIBs in the US is higher than mandated under Basel norms. In addition, there are norms for what is called total loss-absorbing capacity (TLAC), which includes debt that converts into equity if required in a crisis. The US had stipulated TLAC norms that were higher than international banking standards. The Treasury report wants America’s stipulations on all these counts to be “recalibrated,” a euphemism for making these norms less stiff.

The Treasury’s proposals are thus a mixed bag. They certainly do not amount to the bonfire of regulation that some had hoped for and others had feared when Trump was elected President. Improving coordination among the many regulatory agencies that oversee banks’ activities makes sense. Simplification and dilution of the Volcker Rule is not a bad idea. Giving banks a choice of opting for a higher leverage ratio of 10 is also worth pursuing. However, this should not mean exemption from liquidity requirements and stress tests that have come into force since the last crisis. Reducing capital for systemic risk or the TLAC at large US banks would also be a retrograde move.

It is worth underlining that, on the whole, the regulations that have been introduced after the financial crisis have made banking system safer even if not safe enough. Those who wish to significantly roll back the regulations that have been introduced since the crisis need to be reminded of the words of Janet Yellen (2017), chairperson of the Fed, at the annual finance symposium at Jackson Hole, Wyoming, last August:

Economic research provides further support for the notion that reforms have made the system safer. Studies have demonstrated that higher levels of bank capital mitigate the risk and adverse effects of financial crises. Moreover, researchers have highlighted how liquidity regulation supports financial stability by complementing capital regulation. Economic models of the resilience of the financial sector—so called top-down stress-testing models—reinforce the message from supervisory stress tests that the riskiness of large banks has diminished over the past decade.

References

US Department of the Treasury (2017): A Financial System That Creates Economic Opportunities: Banks and Credit Unions, June.

Yellen, Janet (2017): “Financial Stability a Decade after the Onset of the Crisis,” speech at symposium of the Federal Reserve Bank of Kansas City, Fostering a Dynamic Global Recovery, Jackson Hole, Wyoming, 25 August.

Updated On : 16th Oct, 2017

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