Gutting Wall Street capital requirement would be reckless


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The headlines on Sept. 15, 2008, were grim.

Over the past several months,Trump-appointed financial regulators have advanced many proposals that would roll back important financial stability measures put in place following the devastating 2007-2008 financial crisis. Emboldened by these recent victories, Wall Street banks and conservative policy makers in Congress are pressing regulators to water down yet another element of the post-crisis capital framework.

The latest target is a risk-weighted capital requirement known as the G-SIB surcharge. This loss-absorbing equity buffer only applies to the eight most systemically important banks in the U.S. — banks like J.P. Morgan Chase

JPM, -0.98%

 and Goldman Sachs

GS, -1.14%

 . The massive systemic footprint of these financial conglomerates warrants higher loss-absorbing capital requirements relative to smaller banks, given the impact their failure would have on the financial system and broader economy.

Weakening this safeguard would needlessly increase the likelihood of another financial crash.

In the lead-up to the 2007-2008 financial crisis, the banking sector was overly reliant on debt as a source of funding. Banks did not have sufficient equity-capital buffers to safely incur mounting losses following the collapse of the subprime housing market and the chain reaction of financial distress that ensued. Faced with the potential failure of large, complex, and interconnected financial institutions, the federal government stepped in with unprecedented levels of support, including bailouts, debt guarantees, and liquidity facilities.

While much of the financial sector was eventually rescued, the U.S. economy was battered by the crisis. Unemployment shot up to 10%, millions of homes were foreclosed on, and trillions of dollars in household wealth evaporated. In fact, a recent study from the Federal Reserve Bank of San Francisco found that the economic damage caused by the crisis represents a staggering $70,000 in lost lifetime income for every American.

After the financial crisis, there was broad agreement across the spectrum that both the quantity and quality of bank capital — especially at the largest and most complex institutions — had to be improved. The G-SIB surcharge, an additional capital buffer for qualifying banks, was meant to incentivize Too Big To Fail banks to reduce their systemic footprint or require them to internalize the systemic costs of their failure.

The surcharge is calculated for each G-SIB using a range of factors, including the bank’s size, complexity, interconnectedness, cross-jurisdictional activity, and substitutability. As a result of this requirement and other reforms, these banks have doubled their capital levels since the crisis.

Over the past several months, Wall Street banks and conservative lawmakers on Capitol Hill have pressed the Federal Reserve to make changes to the calculation of the G-SIB surcharge. At least six of the eight banks have sent letters to the Fed this year requesting specific adjustments to the calculation of the surcharge. Wall Street trade associations followed suit. Conservative members of the House and Senate have also sent letters to the Fed mirroring the requests and arguments advanced by Wall Street.

Fed officials have not yet taken a firm stance on these specific requests but have committed to considering them in response to questions during congressional hearings. The Fed and Office of the Comptroller of the Currency, however, proposed a rule in April that would lower risk-neutral leverage capital requirements for these same eight banks. The proposed rule would reduce the capital requirements at the taxpayer-insured bank subsidiaries of these G-SIBs by $121 billion, or roughly 20%.

This clearly demonstrates that Trump-appointed regulators are willing to roll back critical elements of the post-crisis capital framework for G-SIBs.

Wall Street’s recommended changes to the G-SIB surcharge are framed as sensible technical fixes to a complex calculation. That is not the case. These banks want lower capital, not a more intellectually sound surcharge calculation.

All of the recommended tweaks would decrease the level of capital required by the surcharge.

None of the banks, trade associations, or conservative lawmakers suggest addressing some of the calculation’s clear shortcomings that—if changed—would result in higher capital levels. For example, the data set used by the Fed to determine bank-default probabilities includes the actual losses sustained by large banks during the 2007-08 crisis, not the losses they would have incurred absent the massive taxpayer support extended to these firms.

In addition, the data set underestimates losses by not including data for the quarter in which a bank failed — a phenomenon referred to as survivorship bias. There is also evidence the surcharge applies to too few banks and underweights the role that short-term funding plays in increasing a bank’s systemic footprint.

These banks also argue that the higher U.S. G-SIB surcharge relative to the surcharge in other countries has harmed U.S. international competitiveness.

That is easily disproven. The top five global investment banks measured by fee income are the subsidiaries of U.S. G-SIBs. In terms of global wholesale banking revenues, the top five U.S. banks gained market share between 2006 and 2016 at the expense of the top five European banks.

Moreover, U.S. bank profits are at all-time highs, while European bank profitability has been notably weak. A well-capitalized, well-regulated banking sector is a clear source of strength for an economy and can provide a competitive advantage globally.

Instead of chipping away at the post-crisis capital framework, policy makers should further strengthen it. Substantial research from the Federal Reserve Board, Federal Reserve Bank of Minneapolis, International Monetary Fund, and countless academics demonstrates that, despite improvement, big bank capital levels are still too low.

Higher loss-absorbing buffers at the largest banks in the country would help the economy over the long-term by further reducing the chances of another financial crisis, even after factoring in the slight expected increase in bank-funding costs associated with higher equity capital.

Higher capital buffers are especially important today, at this stage of the business cycle with risks building in the system. Regulators must prepare for the elevated bank losses that will come with the next economic downturn.

The conversation about reducing Wall Street’s capital buffers, including the G-SIB surcharge, should start and stop there.

Source : MTV