BPEA | Fall 2017

Strengthening and streamlining bank capital regulation

Editor's note:

This paper is part of the Fall 2017 edition of the Brookings Papers on Economic Activity, the leading conference series and journal in economics for timely, cutting-edge research about real-world policy issues. Research findings are presented in a clear and accessible style to maximize their impact on economic understanding and policymaking. The editors are Brookings Nonresident Senior Fellow and Northwestern University Economics Professor Janice Eberly and James Stock, Brookings Nonresident Senior Fellow and Harvard University economics professor. Read the rest of the articles here.

Bank capital requirements shouldn’t be lowered, but post-crisis rules should be simplified to ensure all banks are subjected to a single constraint dictating minimum requirements, according to a new financial regulatory framework outlined in “Strengthening and streamlining bank capital regulation” (PDF) by Harvard’s Robin Greenwood, Samuel G. Hanson, Jeremy C. Stein, and Adi Sunderam. Stein was a member of the Board of Governors of the Federal Reserve System from May 2012 to May 2014.

The Treasury Department in June 2017 released the first in a series of expected reports aimed at evaluating the effects of Dodd-Frank and the post-financial crisis regulatory regime. Treasury’s report included proposals that would effectively relax capital requirements for the largest, most complex financial institutions. The new framework proposed by the authors assesses those regulations most directly tied to bank capital, including the Basel III capital requirements and the leverage ratio, as well as the Federal Reserve’s stress-testing process.

Importantly, the new framework proposed by the authors does not discuss at length how much equity capital the banking system should have in the aggregate, a subject they believe has already been thoroughly addressed in academic research. But they do note it would be “a mistake” to substantially lower capital requirements, writing that “current levels of capital in the U.S. banking industry are near the lower end of what would seem to be a generally reasonable range” and “we suspect that adding a few more percentage points to risk-based capital ratios, especially for the largest banks, would be socially beneficial.”

Discussing their proposed consolidation of capital requirements, the authors note that, under the current regulatory regime, different constraints on bank capital requirements apply to different banks. This approach, they argue, is beginning to create unintended convergence in banks’ business models: “When different constraints bind for different banks—as is clearly the case in [our] data—this is equivalent to imposing different marginal tax rates on the same activity across different institutions…Absent a change in regulatory approach, we are likely to see other worrisome symptoms of non-economic, industry-level adaptation going forward.”

The authors stress that their recommendations apply to constraints on bank equity capital, specifically: “We are not saying that multiple constraints on multiple different items are undesirable. Thus, for example, a separate liquidity coverage ratio, which specifies that a bank hold a minimum amount of high-quality liquid assets, need not create any distortions alongside a binding capital ratio.”

The authors also propose that:

  • In the wake of large negative shock, regulators should compel banks to cut their payouts and issue new equity, but allow banks’ required capital ratios to decline temporarily. The authors consider it “crucial” that the Federal Reserve’s annual stress-testing process not only be geared to normal-times capital ratio regulation, but also stand ready to implement a recapitalization of the industry when the time comes, much like the U.S. government did in the original stress tests in 2009.
  • Regulators should also retain flexibility to adjust some components of capital requirements. One way to do this, they suggest, is to ensure the Fed’s annual stress tests are responsive to market-based indicators of bank solvency, such as their stock prices, as well as to incoming clues about efforts by banks to “game” the tests. Such clues might be found in studying areas of unusually high growth or the activities of the highest paid traders.

Jeremy C. Stein is on the board of directors for the Harvard Management Company, an unpaid position. In the past year, he has given paid speeches for Barclays, Citigroup, Goldman Sachs and JP Morgan, and has served as a consultant to Key Square Capital Management. A full list of Stein’s compensated and significant non-compensated activities since 2006 is available on his website, With the exception of the aforementioned, the authors did not receive financial support from any firm or person for this paper or from any firm or person with a financial or political interest in this paper. With the exception of the aforementioned, they are currently not officers, directors, or board members of any organization with an interest in this paper. No outside party had the right to review this paper prior to circulation.