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Raising the Barr On Bank Capital
Some quick thoughts on the VC for Supervision's opus and the state of bank capital
Fed Vice Chair for Supervision Michael Barr gave what felt like a mic-drop speech on bank capital on Thursday. It’s worth reading in its totality, and it gives some hints on the likely direction (up) and timing (“I hope to have more to say about that review early in the new year”) of capital regs under his tenure. He emphasizes that capital regulation should be undertaken with humility and clearly points to a desire for higher bank capital.
On Bank Capital, Generally
First, I'll begin with what capital is—essentially shareholder equity in the bank. People sometimes use the shorthand of banks "holding capital" when speaking of capital requirements; however, it's helpful to remember that capital is not an asset to be held, reserves to be set aside, or money in a vault; rather, it is the way, along with debt, that banks fund loans and other assets. Without adequate capital, banks can't lend.
True. I’d add though, that without adequately flexible capital, banks can’t lend. It’s also worth noting, that bank capital is not infinite. Bank equity is a scarce resource, and infinitely so in the short-term.
While capital is what leaves the heart of the financial system resilient, the higher you take the requirements, the more banks are going to run their books without “excess” capital, as it’ll be too expensive. And if the requirements don’t provide enough flexibility, we’ll get a world of supremely well-capitalized and stable banks—and constant central bank/sovereign intervention. This more or less describes several markets of late: European power markets, Korean corporate credit, commodities, U.S. Treasuries (in 2020 at least; no Fed intervention of late, yet).
One truism is that it’s tough to get banks to dip into their capital “buffers.” There’s a stigma issue, sure—once you give banks a number, it looks bad if they’re the first to fall below it—but the regulatory penalties start phasing in too. Limits on distributions, comp, etc. This is an argument for lowering the “through the cycle” capital requirement and making more use of the countercyclical capital buffer (CCyB). The Fed’s “normal” value for the CCyB is 0%. It need not be this way. For instance, the Bank of England aims for a normal CCyB setting of 2%—“when risks are judged to be neither subdued nor elevated”—which allows it space to shave bank capital requirements dynamically and hopefully avoid some of the stigma.
However, this still leaves the dynamism in the hands of the regulators. And this is probably fine for a true financial crisis. If there had been a CCyB prior to the GFC, you can imagine regulators having lowered it well before Lehman fails in September 2008.
But, a market crisis—whether it be a breakdown in arbitrage (think Treasuries 2020), a pretty clear chance to go bottom-feeding (think UK pension fire sales to Apollo), or a sudden demand for substantial liquidity without a pursuant increase in capital risks (think lending to the commodities dealer/power producers that became alchemists post-Ukraine invasion)—is always going to be visible on the trading floor before anywhere else. And the assets are going to be more available to the banking system writ large than the central bank. Everyone in financial markets is a bank customer; only a handful are central bank customers.
Yet, clearly there are limits to how much we should trust banks to self-regulate here. Banks “solving” the market crises of 2007—e.g., Bear assisting one of its failed hedge funds, Citi onboarding its toxic ABCP/SIVs, Lehman being overconfident in the real estate market turnaround, etc etc—is what ultimately left the system vulnerable to a financial crisis in 2008.
Banks’ ability to manufacture deposit funding and otherwise use their balance sheet to create leverage is useful during market selloffs: “Trying to get out of that long-term corporate bond holding? Ok, I’ll buy it from you. Also, can I interest you in a short-term repo backed by a corporate bond?”1 This is what makes them the nimble first responders to financial incentives. But it’s also clear how, in the short-run, this makes their balance sheets more fragile. It’s an uncomfortable thing (and probably extra so if you’re the supervisor of just one bank) to think “ok, markets are getting really choppy and bearish, thank god the banks are willing and able to lever up!” But, that balance sheet deployment is also a super important economic equilibrator!
The point is, there probably needs to be a supervisory give-and-take here. Some sort of countercyclical capital buffer that, rather than being turned up and down by the regulators, is instead triggered by the individual banks based on what they’re seeing in the market. You can’t ask bankers to jump in with balance sheet to put a floor under asset markets, enforce arbitrage relationships, and make sure liquidity finds its way to exactly where its needed when its needed if, at the same time, you start cutting into their compensation and their ability to compensate shareholders—because they’ve “used” their capital buffers. In that world, (warning: callback incoming!) capital might as well be “money in a vault.” And this only gets exacerbated to the extent you return to the increasingly dry well supplying bank capital and don’t also increase its flexibility.
It might be more productive if there were some way they could use capital opportunistically and submit that use for supervisory blessing. If we always depend on the reverse, we’ll be in a world with more market breakage, more economic costs, and likely more central bank intervention—despite pristine bank balance sheets. At that point, the Fed and other central banks are the capital providers of last resort…
The intermediation chain is here is often much longer. But the balance sheet outcome is broadly similar.