THE FED´S CAPITAL MISTAKE / THE WALL STREET JOURNAL EDITORIAL

The Fed’s Capital Mistake

Regulators give in to the bank lobby’s wish for more leverage.

By The Editorial Board
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      Photo: emmanuel dunand/Agence France-Presse/Getty Images 
 

Happy days are here again for American finance. Tax reform and rising interest rates are throwing off huge profits, and maybe a little amnesia is setting in among banks and regulators. Lo, the Federal Reserve thinks now is a splendid time to ease capital requirements.

Last week the Fed proposed recalibrating its leverage requirements for the eight globally significant banks (GSIBs). The regulations were enacted after the 2008 financial crisis to ensure that banks maintain adequate capital. The Fed can restrict banks that fail annual stress tests from returning capital to shareholders. 
Recall how investment and commercial banks prior to the crisis piled into mortgage-backed securities, which regulators deemed low-risk. This allowed them to expand their balance sheets while meeting the international Basel Committee’s risk-based capital requirements. But when the housing market crashed, banks were exposed.


The government rescued banks with a capital and liquidity infusion to prevent the financial system from locking up. Banks have repaid the bailout money, and last year they all passed the Fed’s annual stress test for the first time. Over the last year, J.P. Morgan , Citigroup and Wells Fargo have returned some $60 billion to shareholders. First quarter net profits rose 35% from a year ago at J.P. Morgan, 34% at Bank of America and 13% at Citigroup.

Yet now banks gripe that the Fed’s leverage limit is too stringent, and Goldman Sachs CEO Lloyd Blankfein last year complained that banks are overcapitalized. A Morgan Stanley analysis estimated about $120 billion in “excess” capital at the 18 largest banks. What excess?

GSIBs maintain an average 6.6% leverage ratio, which is only slightly more than the losses they experienced during the crisis. Regional and community banks that don’t benefit from an implicit government guarantee on average boast a 8.7% leverage ratio.

Big banks argue that the leverage limit restricts lending. Yet several complained during earnings calls last week that low borrower demand was putting a damper on lending. Which is it? The reality is that better capitalized banks can support more loan growth. Two recent studies have found that a percentage point increase in banks’ equity capital ratio is associated with a 0.6 to 1.69 percentage-point increase in lending growth.

Another bank argument is that the simple leverage limit encourages riskier behavior. But the GSIBs’ risk-based capital exceeds the Fed’s minimums, which suggests they aren’t piling into junk bonds or other speculative investments. If they did, the risk-based limits would kick in.

The Fed has adopted the bank lobby’s view that the 6% leverage limit is too restrictive. Under the Fed’s new proposal, banks would be required to maintain a 3% leverage ratio plus a modest “surcharge” based on their complexity. This would have the effect of reducing capital requirements for the biggest insured depository institutions by an average 20%. Banks could thus take on more leverage and boost returns to shareholders as markets heat up and profits improve. Sweet.

The Fed estimates that its proposal would reduce the amount of tier 1 capital required among the GSIB insured depository institutions by $121 billion. Yet it paradoxically projects only $400 million in relief for bank holding companies, which would supposedly still be bound by “the current risk-based capital requirements, supervisory stress testing constraints, and other limitations.”

But wait. The Fed last week proposed a separate rule to dumb down stress tests. Banks would no longer face restrictions on capital distributions to shareholders if they don’t meet the Fed’s “quantitative” standards. According to the Fed, the “proposal generally would lower the amount of tier 1 capital” a firm would need to maintain during stress. The Fed should clarify how its proposed rule-makings would interact and explain how it foresees banks will deploy the $121 billion in freed-up capital.

Another question is how the Fed’s proposals would be affected by the looming Senate banking bill, which exempts central bank deposits from the leverage limit for custodial banks. This provision would reduce capital requirements by an effective 20% to 25% for State Street and Bank of New York Mellon .

We warned last month that other big banks like Citi and J.P. Morgan would also demand a dispensation, and what do you know? The Fed is soliciting comment on “carving out central bank reserves” from the leverage limit.

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All of this seems short-sighted, not least for the banks. They support easing some of Dodd-Frank’s regulations, and we agree. But then they should support higher capital as protection against bad lending bets or another recession. Instead the banks want less regulation and less capital, which will set them up for Senator Elizabeth Warren’s tender mercies when the next panic strikes.