Capital Regulation Was Supposed to Be Simple & Low Cost... It’s So Far From That Now

Last Tuesday, my colleague Tom Hoenig testified before a House Financial Services Subcommittee hearing on whether banking agencies have legal authority to implement the Basel Guidelines. On the heels of my last post about the likely additional burdens of the Basel III Endgame, this gives me a chance to contrast how simple and low cost capital regulation was supposed to be AND still could be relative to how its evolved since agencies began implementing the Basel Guidelines.

In a classic 1978 article about how to regulate holding companies (and their bank subsidiaries), Fischer Black, Merton Miller and Richard Posner observed that a key merit of bank capital regulation was its low cost. Indeed, the authors wrote the following highly relevant passages:

1)     Since a private lender is concerned with a borrower's capital, especially a borrower with a high debt-equity ratio, the government should be concerned with a bank's capital, and is. (p. 386)

2)     While emphasizing the use of capital requirements to protect depositors (and their insurer, the government), we recognize, of course, that they are not a panacea. They will not prevent embezzlement (a common cause of bank failure) or other employee malfeasance. They will not be effective if the bank offsets the added protection by deliberately increasing the risk of its assets even further. But, given the existing structure of surveillance, they can be a valuable and, as we show next, a relatively inexpensive method of protecting the banks' depositors from any increased risks due to holding company activities. (p. 388)

3)     Capital requirements may take the form of equity capital, of subordinated debt, or of some mixture of the two. Since, contrary to popular belief, the cost to the borrower of reducing his debt-equity ratio may be very low, even zero, capital requirements may be an inexpensive method of borrower regulation in general and of government regulation of banks in particular.

… an increase in the debt-equity ratio increases the risk and thereby increases the risk-adjusted required return of the equity owners. Debt may seem like a less expensive source of funds, but only because the additional risk caused by the use of debt is often ignored. (p. 388)

4)     Raising a bank's capital requirements is thus a relatively inexpensive way for the Federal Reserve Board to offset the added risk created by the holding company's nonbanking activities. It is not only inexpensive for the board; as demonstrated in an earlier section of this paper, it is probably relatively inexpensive for the banks too. (pp. 402-403)

5)     Moreover, if the board is trying to protect depositors and the insurance fund at minimum cost, we think it makes sense for it to regulate the holding company and its subsidiaries only to the extent necessary to assure that the bank has capital sufficient to protect the depositors from risks arising from the activities of the company and its subsidiaries.

We reject the alternative of imposing capital requirements on the holding company itself. To be sure, the greater the capital of the holding company, the less likely it is that the company will become insolvent as a result of mistakes or bad luck in its nonbanking activities and so the less likely it is that the bank's assets will be drawn upon to satisfy the claims of the holding company's creditors. But if the bank's capital is adjusted to offset this risk, regulation of the holding company's capital becomes superfluous. Regulation of the bank's financial structure is preferable because policy is concerned with holding company activities only insofar as they increase the risks of the bank. (p. 404)

6)     In defining "capital" for purposes of the capital requirement, it may make a difference whether the purpose of bank regulation is assumed to be the protection of depositors or the prevention of bank failures per se. If the main purpose is the protection of depositors, there is some (not great) reason to prevent the use of capital notes or debentures of the bank itself to satisfy the requirement, even if they are fully subordinated to depositors' claims, since an increase in debt increases the risk of bankruptcy and bankruptcy costs could reduce the value of the bank's assets and hence the funds available to satisfy the claims of depositors. However, if the main purpose of bank regulation is the prevention of bank failures, the argument against the use of subordinated debt is stronger since accretions of debt increase the probability of failure whatever the impact of failure on the depositors. As noted earlier, however, our view of the nature of bank regulation does not imply a need to prevent bank failures per se. (pp. 404-405)

The words above lay out a clear blueprint for a low-cost regulatory regime, which is simple to implement, while making the banking system more resilient than it currently is. Our current regulatory regime has been heading in a very different direction for a long time. If you’d like a summary of how the Basel Guidelines and the U.S. implementation of those guidelines has evolved you can have a look at Sections 2.1 and 2.2 (and Tables 1 and 3) of a paper Jim Barth and I co-authored some time ago. I will summarize and compare the two approaches and some of their outcomes.

The Black-Miller-Posner Blueprint

To summarize, Black, Miller and Posner suggest that bank capital should consist primarily of equity rather than long-term debt whether regulators aim to prevent banks from failing or to protect depositors. More equity funding reduces leverage, which today comes from deposits but also newer variations of short-term debt funding. Even though long-term debt can serve as capital, funding with more long-term debt, ceteris paribus, also increases leverage. So long-term debt could help protect depositors, but would not prevent banks from failing. In addition, bank capital regulation should apply at the bank subsidiary level, rather than at the holding company level. That’s simple enough, but compare that to what currently happens.

The Current Regulatory Regime: Too Many Complex Capital Requirements & Unintended Consequences

Currently, banks and holding companies have equity capital requirements, and most of the many capital requirements that banks and holding companies are subjected to get measured relative to complex risk-weighted asset measures, rather than debt (see Table 5 of the paper Jim Barth and I wrote). Risk-weighting involves regulators making educated guesses about the riskiness of broad asset classes, and banks hiring many people, for compliance purposes, to measure these complex risk-weights used in the regulatory capital ratios - they’re akin to tax concessions in the tax code. Just as the tax code has spurred the tax preparation services industry, bank capital regulation has created its own "cottage industry” of accounting, legal and “quant” experts and in turn more people who want to keep the Basel framework, while still not delivering the promise of a robust and resilient banking system. That’s because these educated guesses have turned out to be incorrect resulting in significant distress for banks, including the largest ones - exactly the sort of distress that bank equity capital regulation was AND is supposed to guard against. Risk-weighting undermines the effectiveness of equity capital to guard against unexpected losses.

The first time this happened was leading up to and during the 2008 Crisis, as Basel type capital requirements were lowered for highly-rated, private label securitization tranches in 2001; the highly-rated, private label securitization tranches included those from Collateralized Debt Obligation or CDO deals, which lay at the heart of the 2008 Crisis. Also, banks under Basel rules have always had little to no required capital for agency mortgage-backed securities and Treasury securities holdings, yet this past year, these credit-risk safe assets turned out to be the source of the problem, as their prices dropped once inflation and interest rates rose; interest rate risk can be hedged, but some banks did not hedge. These tax concession-like reductions in risk-weights for certain asset classes work to effectively lower the amount of equity capital in the banking system. If equity capital requirements instead aimed at reducing leverage, these events would not likely have happened.

Basel Guidelines have called for a new Total Loss Absorbing Capacity (TLAC) framework, where TLAC includes common equity, but also long-term debt. But once again, as Black, Miller and Posner suggest, if the aim is to prevent banks from failing, which is what TLAC aims to do, then requiring long-term debt works against that objective.

The Current Regulatory Regime: Both Holding Company and Bank Subsidiary Capital Requirements

Currently, we have both bank subsidiary and bank holding company capital requirements. Part of the justification for holding company capital requirements comes from the Federal Reserve’s “Source of Strength” doctrine, which holds that a holding company will come to the rescue of a failing subsidiary. However, that does not always happen.

For instance Paul Kupiec in Section 6 of a lengthy assessment of post-Dodd Frank Orderly Liquidation Authority observes that holding companies have not always served as a “Source of Strength” for bank subsidiaries, as holding companies sometimes outlive the failed subsidiaries. And again, after the events of this past Spring, Silicon Valley Bank's holding company still exists, while its bank subsidiary was allowed to fail! Paul Kupiec’s correct about “Source of Strength”, once again.

Since bank subsidiaries do not issue equity, one way to address the shortcomings of the “Source of Strength” doctrine for bank subsidiaries under the Black-Miller-Posner approach could be to eliminate existing holding company capital requirements, while adding one requiring that the holding company floats sufficient equity to ensure that a bank subsidiary has enough capital to meet minimum requirements. Regulators could still have holding companies report a holding company leverage ratio, but it would be based on aggregating up from and be binding at the bank subsidiary level. Doing so would would help protect depositors and work to prevent the bank subsidiary from failing.

While U.S. banks have long been subjected to a leverage ratio even before the addition of risk-weighted asset ratios, Basel III called for implementing the supplementary leverage ratio (SLR), which here applies to the largest banking organizations. The trouble with the SLR arises with the denominator, which also attempts to account for off-balance sheet activities.

The SLR’s leverage exposure measure remains opaque, and as with risk-weighted asset ratios, the SLR can be increased by increasing equity capital, but also by reducing the denominator, in this case the leverage exposure. So if a holding company does not want to increase equity, it will adjust the ratio by eliminating some activities that get included in the denominator. I suspect this is the key reason for bank complaints about the SLR and the impact on the Treasury market. But again, this arises from the holding company capital requirement, which proves unnecessary for financial stability, if bank subsidiaries remain adequately capitalized.

In short, many thousands of people have spent considerable parts of their lives since the 1980s designing Basel rules, trying to comply with Basel rules, and trying to revise Basel rules to fix “the last crisis”. Black, Miller and Posner put forth a simpler alternative, which could have avoided all of this effort and subsequent financial turmoil. If we followed the Black-Miller-Posner approach along with a minimum equity capital to debt ratio of 15-20 percent or more, there would be more actual capital in the banking system than what we have now. It would be a cheaper-to-comply-with, simpler, higher and more robust capital regime than what we’ve had in recent decades, and would allow banks to allocate more resources to ever-growing threats like cybersecurity.