The Basel III Endgame and Fed independence

On July 27, 2023, the federal banking regulators—the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and the Federal Reserve—proposed sweeping new rules for how large banks must build their balance sheets. Where the previous capital regime under President Trump’s banking regulators preferred more deference to banks to determine these financing decisions, the new rules are broader, bigger, and require banks to make critical decisions that they don’t want to make. The rules even have a cinematic name: We have now entered “Basel III Endgame.”

As a historian of U.S. banking, I struggle to identify a time when banks fought harder against a regulatory decision than this one. Nothing in the Clinton or Obama administrations comes close. We have to look back to the New Deal, when President Roosevelt declared in a campaign speech that bankers were “unanimous in their hatred” of his program, and even then it wasn’t quite true.

Roosevelt famously followed his assertion of unanimous hatred with the quip, “I welcome their hatred.” The Federal Reserve, first among equals in this regulatory proposal, on the other hand, does not welcome banker hatred. In congressional hearings on March 6, 2024, Fed Chair Jay Powell committed to “broad and material changes” to the original July proposal that will command “broad support at the Fed and in the broader world.”

The original proposal passed on a vote of 4 to 2 (there was one vacancy in July 2023). We do not know what Powell’s new standard of “broad support” means, but we can assume he was not satisfied with those two dissents.

The banks’ campaign against higher equity requirements is both technical and theatrical. The proposal itself is dizzyingly complex, normally the kinds of issues reserved for technical experts from across society to argue about amongst themselves. There is good evidence that some of the reforms under consideration are exactly of the kind that we should hope to see from a responsive regulator taking into consideration important costs and benefits that the original proposal did not contain.

We cannot characterize this round of debate as one among experts. It has been unusually high profile. Herein lies the theater. Promises of economic catastrophe are surely exaggerated; the economic literature supports no such argument with any precision. And to be fair, the certainty that higher capital will prevent the next financial crisis is also not available. Setting the appropriate level of capital is a judgment call, a line-drawing exercise that depends largely on how one tolerates and interprets risk.

That very fact—that the right level of capital will not and cannot suddenly occur to all experts—means that we must resolve the question of bank capital through a political process— and the voters elected a Democratic president and his appointees to make these decisions. Admitting as much does not delegitimize the Federal Reserve’s expertise, nor its vaunted independence. The contrary is true: Powell appears to prize Fed independence for monetary policy so dearly that he wants to avoid political fights about regulatory policy. If that is indeed the path the Fed has undertaken, it is the worst of all worlds. He hasn’t avoided a political fight, but joined one by intervening in a way that Republicans and bankers prefer. This failed attempt to insulate regulatory policy from the political majority in the name of protecting monetary policy risks trading away legitimacy for both.

Bank regulation and political accountability

After the financial crisis of 2008, Congress recognized this basic and fundamental division between problems of managing monetary policy insulated from pesky political interference and the need for democratic legitimacy to make judgment calls about financial regulation. Among other changes (such as the creation of the Consumer Financial Protection Bureau in 2010), Congress created a new leadership post at the Fed—Vice Chair for Supervision—to develop proposals, oversee their implementation, and testify before Congress. The idea was that someone within the Fed needed unique accountability for all the Fed would do—or, not do—to implement and execute the laws as Congress enacted them.

The Obama administration didn’t fill the post. They relied instead on Fed Governor Daniel Tarullo to guide the implementation of supervisory and regulatory policy, a task he undertook with vigor and remarkable transparency and accountability. The Trump administration moved quickly to fill the post with Randal Quarles, a former financial regulatory attorney, private equity investor, and alumnus of both Bush administrations. Quarles, like Tarullo, filled his post with vigor and leadership, pushing forward a regulatory and supervisory agenda that reflected that fact that he, like the President that nominated him, was a Republican and a genuine expert in his field. For that reason, Quarles was widely reviled by the Democratic left and celebrated by Republicans.

The 2020 election had consequences. To implement his political priorities in bank regulation and supervision, President Biden nominated, and the Senate confirmed, Michael Barr. Barr, like Quarles before him, was a partisan who had served two stints in the U.S. Treasury and a genuine expert on all matters of financial regulation. It was expected that he would introduce regulatory and supervisory priorities that reflected the preferences of the Democratic coalition that sponsored him.

The July proposal reads like the inverse of what Republicans pursued during the Trump administration. That is, it is a political document in the best sense of that term. It reflects genuine expertise about hard- or impossible-to-measure value judgements that pit risks of private-sector stagnation (when equity is too high) versus financial fragility (when equity is too low).

This is technocratic democracy at its best. There is no expert consensus to consult on the precisely correct level of bank equity, or even of its measurement. The gap between expert consensus and ultimate policy decisions has to be filled somehow. To paraphrase Winston Churchill, filling that gap with democratic elections is a deeply flawed shortcut, but it is better than anything else we have tried.

Jay Powell’s politics

Fed Chair Jay Powell seems not to see it this way. Powell’s view, pieced together from interviews, hearings, and press conferences, appears to be that revisions to the original capital proposal are necessary to ensure it will be, as he has said repeatedly, “broad” in the acceptance that they would receive inside and outside the Fed.

There are significant debates about the wisdom of forced consensus when it comes to the Fed’s responsibilities over monetary policy. I value consensus on these matters less, I think, than Powell appears to do, but his argument has a democratic logic to it. The Fed’s insulation from political interference with respect to monetary policy arises from its need to make decisions about the availability of credit that are not linked to the short-term interests of incumbent political parties. This  “central bank independence” is an article of faith for liberal democracies the world over; its absence is associated with spectacular failures of monetary management.

But whatever logic applies to the Fed’s responsibility for monetary policy, none does to the highly political responsibilities of bank regulation and supervision. Here, the sheer breadth of discretion granted the Fed by Congress provides the Fed with discretion to strike value judgments differently, depending on the consequences of elections.

Powell, despite his apparent earlier defense of the Vice Chair for Supervision as the politically accountable actor in charge of the Fed’s regulatory and supervisory policies, has retreated from this view. He has shifted the goal posts. Broad support inside the Fed is no legal standard; broad support outside the Fed is a deliberate political strategy. No such consensus exists among experts or politicians; why should such consensus exist among bank regulators? The standard that Barr must face is the simple arithmetic of winning a bare majority of his colleagues: He only needs to convince three others that his proposals should become law. No consensus beyond majority exists. We should not invent that standard now.

The recent history of regulatory dissents supports this conclusion. When Lael Brainard, the Democrat now serving as President Biden’s Director of the National Economic Council, was on the Fed Board of Governors, she regularly dissented from Vice Chair Quarles’s regulatory and supervisory priorities. Her dissents—the policies enacted over them—allowed us outside the Fed to follow along and understand what was at stake and how different people with different worldviews engaged with these changes. Today, that dissent pen belongs to Fed Governor Michelle Bowman. Both Brainard and Bowman’s dissents from consensus make it easier for the American public to understand where the line between expertise and value judgment truly lies. A forced consensus attempts to erase that line completely.

It is not clear today that the Democratic coalition has one view on the wisdom of Basel III. Scrutinizing and responding to comments on the July proposal is a healthy part of the deliberative process. But throwing away regulatory reforms preferred by the party that won the last national election does not preserve Fed independence. It makes a mockery of it.