Should Legislators or Regulators Decide on Bank Capital Requirements?
Note: Edited on November 6th.
Note: Edited on November 6th.
Earlier this month, the Senate passed a bipartisan financial regulatory reform bill (S. 2155) aimed at changing rules created by The Dodd-Frank Wall Street Reform and Consumer Protection Act. A recent Washington Post article highlights a debate ahead of the bill’s passage, which would have tinkered with the so-called supplemental leverage ratio (SLR). The SLR was first introduced by federal regulators in 2013 and is one of numerous regulatory measures of bank capital adequacy that aim to minimize the amount of bank funding that’s prone to runs.
Senator Bob Corker (R–TN) is quoted in the article saying, “I’m not sure if we wouldn’t be better off if instead of the Congress weighing in on how these are going to be dealt with, letting [federal regulators] decide.”
Senator Sherrod Brown (D–OH) agreed and it sounds right to me. Regulators might make mistakes, but there’s no reason to think legislators will make better decisions about the details and implementation of capital requirements than regulators.
To see why, consider that legislators have to deal with a wider range of issues than regulators. It therefore seems to make sense for legislators to focus on more general aspects of policy-making, such as the direction of capital adequacy standards (e.g., lower vs. higher capital requirements), leaving regulators with the task of working out the specifics of capital adequacy standards (e.g., simple vs. complex capital requirements, market value or book value measures, etc.).
To get a sense of how Congressional action can have unintended consequences, consider the case of the Gold Standard Act of 1900. Section 10 of the law lowered capital requirements for the smallest national banks, supervised at the time by the only federal banking regulator, the Office of the Comptroller of the Currency (OCC). Bank capital requirements at that time specified dollar values that varied with the size of the town in which the bank was located, rather than a ratio such as total equity capital relative to either total assets or total liabilities.
As Rutgers University financial historian Eugene White explained in a 1983 book, prior to the Act, national banks in towns with under 6,000 inhabitants were required to have at least $50,000 in paid-in capital. Banks in towns with between 6,000 and 50,000 had to have $100,000. Banks in larger towns had to have $200,000. However, the Gold Standard Act lowered the minimum amount of capital that banks were required to have in towns with less than 3,000 inhabitants from $50,000 to $25,000.
With lower capital requirements, it was now easier to establish a bank in small towns, and the number of national banks grew from about 3,500 in 1899 to over 8,200 in 1922. Being smaller and less capitalized, in the years before the Great Depression, many small banks either voluntarily liquidated or failed, as the number of national banks fell to about 7400 by 1929. In the OCC’s annual report for 1931 (p. 9), staff observed that nearly 60 percent of all bank failures during the previous decade occurred at banks that had $25,000 in paid-in capital or less, which likely suggests they were for the most part happening in the smallest towns. In short, Congress opened the door for smaller, and less well capitalized banks to operate, and while it may have taken two decades, the end result was that a large number of the smallest national banks closed.
Fast forward to 2010, and the Dodd-Frank Act seems to embody the principle mentioned by Senator Corker above. Sections 606 and 607 of Dodd-Frank merely called for changing the language from “adequately” to “well” capitalized, leaving the details to the regulators. One of the key problems with Dodd-Frank is that it does not seem to close the door to the “Too-Big-to-Fail” problem; the law also spurred large increases in the regulatory burden facing financial intermediaries, which have brought on calls to revise the Dodd-Frank approach. Like the Gold Act of 1900, some recent legislative initiatives have focused on changing the specifics of capital requirements.
For instance, out of concern that Dodd-Frank did not end the “Too-Big-to-Fail” problem, a 2013 Brown-Vitter bill was introduced to make the largest banking organizations fund at least 15 percent of their total consolidated asset holdings with equity. One problem with this proposal is that it might make sense to apply it not just to the largest banks. My co-author Professor James Barth and I show in a recent working paper that a 15 percent equity to asset ratio applied to all banks has benefits that outweigh the costs.
Then came the House Financial Services Committee’s H.R. 10 Financial Choice Act of 2017, which offered commercial banking firms a choice between facing 1) lower, but more complex risk-based capital requirements together with the full weight of Dodd-Frank regulatory burdens, and 2) slightly higher capital requirements, through a simpler 10 percent equity-to-total asset “leverage ratio” but fewer regulatory burdens. While that may sound reasonable, some banks may not opt for higher capital requirements, since the regulatory burden may keep out the competition, and as my co-author Professor Barth and I show, maybe a 10 percent equity to asset ratio is too low.
More recently, Rep. Rob Pettinger (NC–09) sponsored H.R. 2148, which would make adjustments to capital requirements on highly volatile commercial real estate (HVCRE). According to an analysis from the Congressional Budget Office, the proposal would lower the risk-weight on HVCRE investments, which means that for every dollar of such investments between 8 and 10.4 cents of funding should come from capital, instead of the minimum 10.4 cents that regulators in late 2017 had proposed (specifically, the regulator proposed lowering the risk-weight to 130 percent from the 150 that existed, which meant 10.4 cents on the dollar instead of 12 cents adopted after U.S. Basel III guidelines were finalized). While the change may be small, this lowers capital requirements for a small class of assets, which does not seem to be a way to foster financial stability. Subsequently, Senators Doug Jones (D–AL) and Tom Cotton (R– AR) introduced S. 2405, which mimicked H.R. 2148. Meanwhile, However, S. 2105 proposes to limit the 150 percent risk weight to HVCRE loans that are deemed to be acquisition, development, or construction (ADC) loans.
All told, the old adage that “too many cooks spoil the broth” seems to apply here. Attempts by legislators to modify already complex capital requirements to suit special interests will likely result in the same kind of growing complexity observed in the tax code, and it might be hard to undo that complexity. Efforts by regulators that rely on complex, risk-based capital requirements don’t seem to foster financial stability, either. After all, the benefits of simpler, higher regulatory capital requirements outweigh the costs. Hopefully, Congress and the regulators can agree on that principle, leaving Congress with responsibility of specifying the general direction of any policy changes, and regulators with the responsibility of working out the details of regulation.