What Treasury’s financial regulation report gets right—and where it goes too far

The Treasury’s recent reassessment of many of the provisions of the Dodd Frank Act, the much-needed toughening of financial regulation that followed the devastating global financial crisis, is a considered and incremental set of proposals. Some of the recommendations would significantly reduce regulatory burden without increasing risks of another financial crisis. Those are welcome, and likely economically beneficial.  But proposed pullbacks in capital requirements for the largest, most complex firms would undermine stability in the financial system and economy. These pullbacks include adjustments to the leverage ratio and an off-ramp for significant regulation and supervision, and are unwise.

Reducing regulatory burden without increasing risks

In the first category of welcome recommendations, the Treasury proposes significant regulatory relief for community banks, an important source of external credit for small businesses. Importantly, community banks can and do fail without risking the stability of the broader financial system. The FDIC closed 465 community banks from 2008 to 2012 without causing broad financial distress.

The Treasury would explore exempting community banks and credit unions from the risk-based capital regime of Basel III, a step that regulators could take without legislation. It would also reduce the number of firms that have mandatory company-run stress tests, a step that requires legislation. As I mentioned in a recent paper, many banking firms could be exempted from stress tests without a material increase in financial stability risks. There could be net gains from granting relief to the 69 firms with assets between $10 billion and $50 billion from mandatory Dodd-Frank company-run stress tests, and to the smaller and less complex firms with more than $50 billion in assets from both company- and supervisory-run stress tests.

In addition, Treasury would exempt banks with less than $10 billion in assets from the Volcker Rule and would exempt banks with greater than $10 billion in assets from the propriety trading restrictions, unless they exceed a threshold amount of trading assets and liabilities. These proposals would reduce compliance burdens without seriously compromising the Volcker Rule’s intent to limit systemic risks from proprietary trading.

While criticizing the complexity of the U.S. financial regulatory system, the Treasury does not propose radical restructuring. It does support a greater role for the Financial Stability Oversight Council, a body created by Dodd Frank that includes all the major regulatory agencies and is chaired by the Secretary of the Treasury. It highlights a need for greater information sharing and coordination among the regulatory agencies. This is encouraging because regulatory agencies working without substantive interactions could miss emerging risks that fall between the cracks of existing authorities.

The report’s problematic recommendations

Some Treasury recommendations would significantly increase risks to financial stability. Among them:

Altering the calculation of the supplementary leverage ratio. The Treasury proposes to alter the calculation of the supplementary leverage ratio, defined as Tier 1 capital divided by the sum of on-balance sheet assets and off-balance sheet exposures. It would allow banks to deduct cash on deposit with central banks, U.S. Treasury securities, and initial margin for centrally cleared derivatives from the denominator. These deductions would significantly reduce the amount of equity a bank would need to meet current leverage requirements. But more fundamentally, such changes would undermine the primary value of the leverage ratio, which is to provide a simple and transparent non-risk-weighted capital ratio.    

Using the leverage ratio to get on the “regulatory off-ramp.” The Treasury also proposes, as does the CHOICE Act that recently passed the House, to use the leverage ratio as the entry fee for a “regulatory off-ramp.” An institution with a 10 percent leverage ratio could escape the tougher regulatory constraints imposed on others, including all capital and liquidity requirements, nearly all aspects of Dodd-Frank’s enhanced prudential standards, as well as the Volcker rule. While a 10 percent leverage ratio applied to current balance sheets would lead to more capital in banks that took this route—and would reduce their risks—the incentive to take the off-ramp could have unwelcome effects. Banks would have incentives to increase their risk exposures since they are not penalized for higher risks.  And banks not required to conduct stress tests would have less incentive to maintain strong risk management practices. This proposal would over time lead to a much riskier, not more stable, financial system.

The combination of changing the calculation of the leverage rates and using the leverage ratio as the entry fee for the “off-ramp” is especially troubling. The effective leverage ratio would be lower if certain assets are excluded, and over time the exposures would become riskier.

Subjecting stress-testing and capital planning to public notice and comment. Another recommendation that would undermine financial stability is to require the Federal Reserve to subject its stress-testing and capital planning review frameworks to public notice and comment. The public notice and comment would apply to its models, economic scenarios, and other material parameters and methodologies. If the Fed were required to put out its models and scenarios for comment for each stress test—essentially provide a “take-home” exam—the stress tests could become ineffective. Models would become rigid, which would make them useless when risks are changing. Banks would adjust their balance sheets to reduce their capital requirements for a specific scenario, and then re-adjust once the starting balance sheet values used for the stress tests were determined.

Policymakers should take lessons from the stress tests imposed on Fannie Mae and Freddie Mac before the crisis. Public notice and comment on models and scenarios led to the all the details being made public and to inflexible models because of the high costs of making changes. Scenarios with house price declines produced only mild losses for the GSEs, just before they were determined to be insolvent and ultimately received $187.5 billion in government assistance.

At the same time, the Federal Reserve needs to continue to improve transparency for both accountability and market discipline. But this Treasury proposal goes too far.

Prematurely revisiting new capital charges for systemically important banks. The Treasury calls for revisiting the capital surcharge for global systemically important banks (GSIBs), and minimum debt requirements to meet a new total loss-absorbing capacity (TLAC) requirement, which is designed to reduce the systemic impact of a failure of a GSIB. None of these requirements apply to community banks, and thus likely reflect the pleas from the biggest banks to dilute capital requirements. In any case, these requirements are relatively new and it would be premature to make strong conclusions about their effects on lending or financial stability. Moreover, these regulations have built-in off-ramps, in that banks that want to avoid these requirements can choose to become less complex and interconnected.

Conclusion

The Treasury emphasizes concerns with so-called lackluster bank lending. But outside of residential mortgages, bank credit growth has not been weak and indeed has been quite strong in some areas. From 2012-2016, C&I loans grew at an average rate of 9.2 percent each year, and commercial real estate loans grew at a 5.9 percent rate. Much of the sluggish growth in residential mortgages during this period is likely due to lack of clarity on the future of the mortgage market and to the number of households who remained underwater on their mortgages. While some small businesses may find themselves unable to borrow because the real estate they offer as collateral isn’t worth what it once was, bankers responding to the Fed’s Senior Loan Officer Opinion Survey do not report a significant difference in lending standards for C&I loans to small and large firms, or significant differences in demand. The National Federation of Independent Business survey of its member finds that for the roughly 30 percent of small businesses that borrow roughly once every three months, loan availability has improved considerably since the depths of the crisis, and is about at levels of the mid-2000s. Still, proposals to reduce excess regulatory burden should be pursued, but they should not be grounded solely on claims that bank credit is restrictive and unavailable.

Overall, the Treasury report offers an array of recommendations to Congress and regulators to reduce excessive regulatory burden which will likely yield important benefits for banks and borrowers. These include proposals to offer regulatory relief to community banks from some capital requirements and the Volcker rule. However, proposals that would effectively relax capital requirements for the largest, most complex financial institutions would make the system more prone to another financial crisis with significant risks to the economy.