Federal Reserve Vice Chair Barr’s Speech on Capital: Part VIII in Our Series on US Bank Capital Requirements

• In a speech^[1] delivered on October 9^th, 2023, Federal Reserve Vice Chair for Supervision Barr laid out his rationale for dramatic increases in capital requirements for trading and market making (i.e., capital markets) activities as part of the U.S. Basel Endgame proposal.
• While limiting himself to quantifying the proposal’s impact on bank lending (apparently limited to credit risk, without taking into account operational risk), he ignores the fact that three-quarters of debt and equity funding to U.S. businesses and local governments is obtained through the capital markets and not via traditional bank loans. The largest banks form the foundation of these capital markets, providing liquidity and facilitating access to these crucial sources of funding.
• As Vice Chair Barr notes, the largest impacts of the proposal will be on bank trading activities. Indeed, if implemented as written, the proposal will:
  • Substantially increase the cost of providing capital markets services to end-users such as U.S. businesses and state and local governments;
  • Reduce the supply of funding through the U.S. capital markets;
  • Result in less competition and capacity in key U.S. capital markets; and
  • Result in reduced market depth, particularly during periods of stress, with negative consequences for U.S. financial stability.
• Some U.S. sources of funding, such as securitizations, securities underwriting, equity investments in funds, securities borrowing, and derivatives, will be particularly negatively impacted. This impact would fly in the face of one of the conclusions of a Federal Reserve research paper on the impact of COVID-19 on the U.S. bank regulatory framework, namely, that “trading activity strengthened firms during this period.”^[2]
• Vice Chair Barr’s argues that these dramatic increases in capital requirements for capital markets activities by large U.S. banks are justified a) because such “activities have generated outsized losses at large banks” and b) because these are “areas where our current rules have shortcomings.” Yet Vice Chair Barr does not provide any example of widespread losses from capital markets activities that have occurred since the 2008 Global Financial Crisis (“GFC”). Rather the opposite; he observes that the quality and quantity of capital has vastly improved in the last 15 years because of post-GFC reforms, stating that the common equity capital ratio of the largest U.S. banks has increased from 5.5% in 2009 to 12.4% at the end of 2022.
• Vice Chair Barr also asserts there are shortcomings in the current U.S. capital framework for trading activities by the largest U.S. banks. Yet the shortcomings he refers to are already substantially captured under the Global Market Shock (“GMS”) component of stress testing and the resulting Stress Capital Buffer (“SCB”) requirement that applies to all large U.S. banks.
• As we note below, the proposed requirements for capital markets activities capture market risk by requiring firms to estimate potential losses to trading positions based on extreme movements in market prices over a regulators-set period of time (i.e., liquidity horizon), calibrated to historic periods. As the existing GMS framework applies to the same positions and applies similar shocks, the proposal effectively captures the same risk twice, first by the proposed amendments to the market risk capital rule and second by the SCB, leading to significantly higher capital requirements than are justified by the underlying risks involved. The Federal Reserve should either eliminate or reform the GMS to eliminate this over calibration of market risk requirements.
• Finally, Vice Chair Barr argues that higher capital requirements are justified by the immense economic costs of financial crises. Yet he does not cite the extensive body of research on the optimal level of bank capital — i.e., research that has examined both the benefits and costs of higher capital requirements. Indeed, a recent independent study of post-crisis reforms and the academic literature on the optimal level of capital by PwC found U.S. capital levels to be close to optimal.^[3]

Introduction

On October 9^th, Federal Reserve Vice Chair for Supervision Michael Barr delivered remarks entitled “Capital Supports Lending” to the American Bankers Association Annual Convention. Vice Chair Barr used the opportunity to discuss why he felt the benefits of the U.S. Basel III Endgame capital proposal outweighed the costs.

In his remarks, Vice Chair Barr admits that the proposal “may result in higher funding costs” but suggests that those costs will be limited because “the effective rise in capital requirements related to lending activities is a small portion of the estimated overall capital increase,” going on to say that “such a rise might be expected to increase the cost to banks for funding the average lending portfolio by up to 3 basis points – 0.03 percentage points.”  Leaving aside that this estimate appears to based on the expected capital increases for credit risk – and does not take into account capital increases for operational risk from lending activities – it ignores the fact that three-quarters of the debt and equity funding for U.S. businesses and state and local governments is obtained through the U.S. capital markets rather than the type of traditional bank lending that predominates in almost every other major country. The largest U.S. banks play a crucial role in facilitating access to debt and equity funding and ensuring liquidity in U.S. capital markets, with the U.S. G-SIBs providing 50% of those trading and market making services to U.S. businesses and state and local governments.

What are the likely impacts of the Basel Endgame proposal on the U.S. capital markets and economy?

This is why the Basel Endgame will have a far greater adverse impact on the U.S. economy than Vice Chair Barr acknowledges. As he notes in his remarks, the capital markets activities of the U.S. banks will be the most heavily penalized by the Basel Endgame proposal, with the Federal Reserve’s own estimates indicating that it will lead to a massive 75% increase in the aggregate risk-weighted assets (“RWA”) attributable to capital markets activities by U.S. banks. That figure may be an underestimate given the over calibration of risks between the market risk portions of the proposal and the existing Global Market Shock (“GMS”) component of stress testing and the resulting Stress Capital Buffer (“SCB”) requirement. This is an issue we have highlighted previously and discuss below. We have also previously described numerous examples of U.S. “gold-plating” of the Basel standards, such as including a far broader range of covered securities, counterparties, and higher collateral requirements than the Basel standards require. This is in addition to the capital increases that will be imposed by the agencies’ separate G-SIB Surcharge proposal.^[4]

Those capital increases will lead U.S. banks to significantly scale back their capital markets businesses, leading to higher funding costs and reduced market access for a variety of a wide variety of U.S. businesses and other market participants, including commercial businesses, asset managers, retirement funds, and state and local governments. Competition and capacity in key markets will be reduced, with no guarantee that other market participants will step in to provide services that the U.S. banks can no longer economically provide. Moreover, market liquidity will be reduced, particularly during periods of stress, including in key funding markets such as the U.S. Treasury markets, which will have negative consequences for overall U.S. financial stability.

Such a result would ironically fly in the face of the Federal Reserve’s own findings in a working paper that assessed the impact of COVID-19 on the U.S. bank regulatory framework, which stated: “The elevated trading activity in the early stages of the crisis led to an increase in fees, commissions and bid-ask spreads, sustaining the profitability of large banks. In addition, firms also issued corporate bonds and equity at a rapid pace to bolster their balance sheets, leading to increases in underwriting fees. Reflecting in part the limitations on proprietary trading put in place following the financial crisis, no major bank suffered sizeable losses on their portfolios. As such, trading activity strengthened firms during this period.”^[5]

Some capital markets activities will be particularly negatively impacted, becoming significantly more expensive or less accessible as a result of these unwise proposed rules. These include:

• Securitized products trading, which helps lower borrowing costs for U.S. businesses, diversifies and reduces the concentration of risk in the financial system and strengthens market liquidity (e.g., the mortgage-backed securities markets).
• Securities underwriting, a crucial service that enables U.S. businesses and state and local governments to raise debt and equity capital;
• Equity investments in funds, which are important sources of funding for U.S. businesses, especially small and medium-size companies including U.S. technology start-ups;
• Securities borrowing transactions, which are used to generate income for U.S. pension/retirement funds and helps increase market liquidity; and
• Derivative transactions, including those used by U.S. businesses and other end-users to hedge non-financial risks.

Are Vice Chair Barr’s justifications for these capital increases supported by the facts?

Vice Chair Barr argues that these dramatic increases in the capital requirements for capital markets activities are justified a) because such “activities have generated outsized losses at large banks” and b) because these are “areas where our current rules have shortcomings.”  But the losses Barr is referring to appear to be those incurred during the 2008 Global Financial Crisis (“GFC”) of 2007-2008 rather than anything that occurred in the following 15 years. Since that time, as he admits, “the current capital rule was updated to better reflect [trading and market making activities] risks.” Indeed, Vice Chair Barr highlights some of the significant post-crisis reforms that improved the quality and quantity of capital, which he notes has led to an increase in the common equity capital ratio (the most loss-absorbing form of capital) of the largest banking organizations, from 5.5% in 2009 to 12.14% at the end of 2022 (an approximately 120% increase).

Those post-GFC capital reforms include:

• The first round of global Basel III standards on capital, which resulted in new bank capital rules for U.S. banks, including for market risk, in 2012 – 2013;
• The minimum capital requirement floors mandated by the Collins Amendment to the Dodd-Frank Act;
• The introduction of the supervisory stress testing requirements, which are now incorporated into regulatory capital requirements via the SCB;
• The capital surcharge on global systemically important banks (i.e., the “G-SIB Surcharge”); and
• The introduction of an extra layer of Total Loss Absorbing Capital (“TLAC”) requirements that can be used to recapitalize the operations of a failing G-SIB and allow for its orderly wind-down without any loss to the Deposit Insurance Fund or taxpayers or any adverse impact on U.S. financial stability.

Moreover, these enhanced financial resource requirements have been supplemented by new resolution planning requirements; enhanced supervision and risk management requirements; and measures to reduce counterparty and trading risks, including the introduction of central clearing and margin requirements for non-cleared derivatives, among other changes.

Policymakers have widely acknowledged the success of these capital and related reforms. For example, Federal Reserve Chair Jerome Powell noted in his statement accompanying the release of the Basel Endgame proposal, “the development and implementation of the Dodd-Frank Act and the Basel III accords followed a deliberative and thoughtful process that evolved over a period of several years” and as a result the “U.S. banking system is sound and resilient, with strong levels of capital and liquidity.”^[6] Commenting on recent stresses in the financial sector, Treasury Secretary Janet Yellen noted that the post-crisis capital and liquidity reforms had helped the banking system weather recent stresses, observing, for example, that “during the March 2020 panic, banks served as an important pillar of strength for the financial system” and that the banking system as a whole had remained strong and relatively stable even as concerns grew about specific regional institutions earlier this year.^[7] It is notable that neither of these recent stress events were connected to trading losses at banks.

In sum then, it is not clear what event triggered U.S. regulators to propose such a significant increase in the capital requirements for capital markets activities over and above the highly successful reforms that were instituted in the wake of the GFC. Indeed, the Basel III Endgame standards were never designed with the intention of increasing capital levels, given that that objective had already been achieved by earlier reforms. For example, the Basel Committee stated in 2017 that the Endgame reforms “will not significantly increase capital requirements overall.”^[8] Instead, the objective of the Basel Endgame standards was to “reduce excessive variability”, “facilitate the comparability of banks’ capital ratios”, and “constrain the use of internally-modelled approaches.”^[9]

This leads us to Vice Chair Barr’s second justification for significantly raising the capital requirements for capital markets activities: addressing shortcomings in the current framework for market risk. As Vice Chair Barr correctly notes, the market risk component of the current U.S. capital rules was designed to address two specific issues: first, that “the current framework could result in capital requirements increasing during stress, rather than requiring firms to hold sufficient capital in advance of the stress to be managed through a stress period”, and second that current framework does “not account for the large range of liquidity profiles across trading exposures.”

However, these shortcomings are already substantially addressed in the U.S. capital rules through the GMS component of stress testing and the resulting SCB requirement. The supervisory stress tests have been the binding capital constraints for large U.S. banks since their inception in 2012, and the SCB requirement was finalized in 2020.  According to the Federal Reserve, the GMS is calibrated to “[reflect] general market distress and heightened uncertainty”, and “[t]he calibration horizons reflect the variation in the speed at which banks could reasonably close out, or effectively hedge, risk exposures in the event of market stress. The calibration horizons are generally longer than the typical times needed to liquidate exposures under normal conditions because they are designed to capture the unpredictable liquidity conditions that prevail in times of stress.”^[10] The GMS is designed to reflect a market shock that “the [Federal Reserve] Board deems to be plausible, though such movements may not have been observed historically”.^[11]  However, a SIFMA 2019 GMS study demonstrates that GMS scenarios since 2012 have been empirically implausible.^[12]

The proposed amendments to the market risk capital requirements in the Basel III Endgame proposal are designed to capture the same risks in a similar manner as the GMS.  Thus, the trading and market making activities of the U.S. banks would effectively be subject to duplicative capital requirements—first, by the proposed amendments to the market risk capital rule and second by the GMS component of stress testing and the resulting Stress Capital Buffer requirement.  This duplication will lead to significantly higher capital requirements for U.S. banks subject to the U.S. stress testing requirements. Thus, should the banking agencies move forward with implementing the proposed amendments to the market risk capital rule, they should make changes to stress testing scenarios to eliminate the over calibration of risks, either by eliminating the GMS altogether; redesigning it to be reasonably plausible; or setting capital requirements as the greater of the new market risk capital rule and the GMS, rather than the sum of the two components (as we discuss in Part IV of our blog series on the Basel capital requirements).

Finally, in Vice Chair Barr includes a third justification for higher capital requirements in his speech by referring to research on the significant economic costs of financial crises. Notably, Vice Chair Barr does not cite the extensive body of research on the optimal level of bank capital — i.e., research that has examined both the benefits and costs of higher capital requirements. Indeed, a recent independent study by PWC of post-crisis reforms and the academic literature on the optimal level of capital found U.S. capital levels to be close to optimal – that is, at a level that appropriately balances financial stability with the economic costs of higher capital requirements.^[13]

Conclusion

Vice Chair Barr makes three claims in support of the proposed significant increase in the capital requirements for trading and market making activities in the U.S. Basel Endgame. He argues that trading and market making “activities have generated outsized losses at large banks”; that this is an area where “our current rules have shortcomings”; and that increases are justified by the immense costs of financial crises. However, these claims are contradicted by the facts.

The comprehensive post-GFC capital reforms, as well as other prudential and systemic reforms, have helped to prevent significant trading or market making losses at the largest U.S. banks, even during the market volatility of March 2020 and the more recent stresses witnessed in the U.S. regional banking sector. The shortcomings that the proposal’s market risk capital reforms are designed to address are already captured under the U.S. stress testing framework; indeed, the Federal Reserve should act to eliminate the over calibration of risks that would occur if the proposal is implemented as proposed without reforms to the GMS component of the SCB. Finally, Vice Chair Barr ignores the wide body of research on the optimal level of capital, including a recent independent study by PWC that finds that U.S. capital levels are near optimal levels at present – that is, they balance financial stability with the economic costs of higher capital requirements.

Authors

Dr. Peter Ryan is Managing Director and Head of International Capital Markets and Strategic Initiatives for SIFMA

Dr. Guowei Zhang is Managing Director and Head of Capital Policy for SIFMA

Footnotes

^[1] https://www.federalreserve.gov/newsevents/speech/barr20231009a.htm

^[2] Aboud, Alice, Elizabeth Duncan, Akos Horvath, Diana Iercosan, Bert Loudis, Francis Martinez, Tiomothy Monney, Ben Ranish, Ke Wang, Missaka Warusawitharana, and Carlo Wix, “COVID-19 as a Stress Test:  Assessing the Bank Regulatory Framework” (2021), Finance and Economics Discussion Series 2021-024.  Washington:  Board of Governors of the Federal Reserve System, https://doi.org/10.17016/FEDS.2021.

^[3] https://www.pwc.com/us/en/industries/financial-services/library/our-take/basel-iii-endgame.html

^[4] For more on the G-SIB Surcharge reforms, see: https://www.sifma.org/resources/news/the-federal-reserve-should-revise-the-us-gsib-surcharge-methodology-to-reflect-real-risks-and-support-the-economy/#:~:text=The%20GSIB%20surcharge%20requirement%20reflects,higher%20the%20applicable%20GSIB%20surcharge.

^[5]  Aboud et al. (2021), p. 4.

^[6] https://www.federalreserve.gov/newsevents/pressreleases/powell-statement-20230727.htm

^[7] https://home.treasury.gov/news/press-releases/jy1376

^[8] https://www.bis.org/bcbs/publ/d424.pdf

^[9] Basel III: Finalising post-crisis reforms Announcement to finalise Basel III reforms https://www.bis.org/bcbs/b3/finalisation_20171207.htm

^[10] https://www.federalreserve.gov/newsevents/pressreleases/files/bcreg20230209a1.pdf

^[11] https://www.ecfr.gov/current/title-12/chapter-II/subchapter-A/part-252

^[12] https://www.sifma.org/wp-content/uploads/2019/09/SIFMA-GMS-LCD-Study-FINAL.pdf.

^[13] Refer to PWC study.

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