Optimism or complacency: The Fed’s Basel capital buffer decision
Under US President Donald Trump, federal agencies have implemented a broad program of financial deregulation. New measures have limited the number of banks deemed systemically important and freed the de-designated banks from the need to undergo stress tests or submit insolvency plans. The Federal Reserve has lowered the minimum liquidity coverage ratio for some of the country’s larger banks and, more recently, has voted not to impose the countercyclical capital buffer (CCB) created by Basel III. These measures have helped boost bank profitability. Some, however, worry this deregulation agenda may create new risks.
In March, the Federal Reserve voted to keep the CCB for large banks operating in the US at 0%. The CCB is a mechanism introduced by Basel III to require banks to increase their capital reserves during periods of strong economic growth so that they are adequately capitalized when the economic cycle turns.
As the US enters the tenth year of its economic recovery – now one of the longest in US history – some have suggested that the Fed should activate the CCB to encourage banks to increase capital ahead of an inevitable downturn.
However, according to a recent speech on the CCB by the Fed’s Vice Chair for Supervision, Randal K. Quarles, the Fed sees “many reasons to expect relatively strong growth in the coming years, supported by gains in the productive capacity of the economy,” and, therefore, is comfortable maintaining a zero CCB in what amounts to “a normal risk environment.”
According to Quarles, then, the Fed sees no sign of a potential slowdown in the coming years and, thus, no need to require banks to build up their reserves.
However, the Fed also voted in March to hold interest rates steady and announced it would be slowing the process of unwinding its sizeable balance sheet, with the goal of ending the unwinding entirely in September. The Fed also released projections for the upcoming year, cutting its 2019 growth forecast to 1.9%.
Many observers interpreted this dovish decision as a sign of the Fed’s growing concern about the risks posed by slowing US economic growth, global trade disputes, and the end of the economic stimulus generated by the 2017 tax cuts.
Therefore, while the Fed’s decision to keep the CCB at zero suggests confidence in the strong economy, its decision to end rate tightening suggests significantly more uncertainty about the economic outlook. Some critics have pointed out that the CCB is intended for exactly such periods of economic uncertainty.
According to Gregg Gelzinis, a policy analyst at the Center for American Progress, “The Fed’s refusal to activate the CCB completely ignores the lessons learned from the 2007–2008 financial crisis. During positive economic times, as risks develop under the surface, regulators should strengthen financial safeguards to bolster the banking system in advance of the next economic downturn. As noted in the Fed’s own financial stability report… valuations across many asset classes are stretched, corporate leverage is near a 20-year high, and riskier firms have been increasing their debt the most. Now is the time for regulators to enhance the resiliency of the banking sector.”
In contrast, however, Quarles argues that the Fed’s current requirements are adequate.
“Because we set high, through-the-cycle capital requirements in the United States that provide substantial resilience to normal fluctuations in economic and financial conditions, it is appropriate to set the CCB at zero in a normal risk environment,” he said.
History shows that financial services regulation is cyclical. During times of financial crisis and recession, regulators enact new rules addressing the weaknesses that caused the crisis. Then, during expansions, complacency sets in and regulatory frameworks are dismantled until a new financial vulnerability ignites a new crisis.
As the US recovery continues, many believe that banks have put the errors of the past behind them and are on a firm footing, justifying further deregulation and monetary accommodation. Others worry that we are witnessing the complacency that precedes a fresh crisis. Developments over the next eighteen months may offer some clarity about who is correct.
Intuition Know-How has a number of tutorials that are relevant to ALM and FinTech:
- Basel III – An Introduction
- Basel III – Pillar 1 & Capital Adequacy
- Basel III – Measurement Approaches
- Basel III – Liquidity & Leverage
- Basel III – Pillar 2 & ICAAP
- Basel III – Pillar 3 & Risk Reporting