Rising financial risks should make the Fed wary of loosening rules

·Contributor
·6 min read
Randal K. Quarles, vice chairman of the Federal Reserve Board of Governors, testifies before a Senate Banking, Housing and Urban Affairs Committee hearing on
Randal K. Quarles, vice chairman of the Federal Reserve Board of Governors, testifies on Capitol Hill in Washington, U.S., December 5, 2019. REUTERS/Erin Scott

The writer is former Chair of the FDIC and former Assistant Secretary of the U.S. Treasury for Financial Institutions.

In the annals of financial crises, perhaps there is no better predictor of impending doom than when financial regulators start loosening regulations. Throughout history, they have shown a remarkably consistent tendency to ease up during economic booms, facilitating reckless lending and asset bubbles. Then they crack down after the inevitable crises ensue, starving households and businesses of credit when they need it the most. Last year, in response to the economic devastation wrought by COVID-19, regulators wisely broke that mold. 

As the economy went into freefall, they gave banks flexibility to deal with distressed borrowers and allowed them to dip into capital buffers to expand lending capacity. But now, with recovery at hand, the economy is flashing warning signs of over-heating: accelerating consumer price inflation; ever-rising equity, commodity, and home prices; and irrational speculation (Dogecoin, meme stocks). In this environment, one would hope regulators would see the wisdom of tightening standards. Unfortunately, the Fed’s leadership seems to be headed in the opposite direction.

In recent remarks to Politico, the Fed’s Vice-Chair of Supervision, Randy Quarles, said he was not sure the current policy was “quite the right answer” with respect to the supplementary leverage ratio (SLR), an overarching constraint on the use of excessive leverage by banking organizations with assets greater than $250 billion in assets. The SLR is a relatively simple metric, requiring that these large banking organizations fund themselves with a minimum percentage of equity. 

The largest megabanks (also called global systemically important banks, or G-SIBs) are subject to an enhanced supplementary leverage ratio (ESLR) of 5% for the holding company, and 6% for their FDIC-insured bank subsidiaries. To be clear, that means that these organizations and their banks can still fund, respectively, with debt to equity ratios of about 19-to-1 or 16-to-1. These modest constraints have long been criticized by big banks as “risk insensitive” since they do not vary based on the perceived riskiness of their assets (in contrast to risk-based capital ratios, which banks can manipulate by changing their asset mix).

Regulators provided temporary relief from the SLR during the pandemic, but Quarles apparently wants to reinstate that relief and make it permanent. His argument: that the SLR is constraining the capacity of large banks to accept deposits. The Fed allowed that temporary relief to expire at the end of March but the Fed will open up public comment on “modifications” that could be permanent.

The banking system is awash with money, the result of massive monetary and fiscal stimulus, and banks need more flexibility to place it in Treasury securities or their own “reserve” bank accounts at the Fed. Both Treasuries and reserve accounts are “risk-free” assets, and thus should be excluded from any capital requirements as the argument goes.

Quarles is criticizing the SLR for doing its job

The problem is that removing Treasuries and reserves from the SLR calculation would result in a significant reduction in required minimum capital, at a time when, if anything, regulators should be increasing capital levels. As I wrote for Yahoo Finance last year when such temporary relief was granted during the pandemic, the four largest banks alone were able to remove $1.6 trillion from the ESLR. Moreover, while central bank reserve accounts are as close as anything to being “risk free,” the same cannot be said of U.S. Treasuries, which pose substantial risk of market losses if interest rates rise. In addition, unlike reserve accounts, Treasury securities can be used by banks to increase leverage when re-hypothecated as collateral to support additional borrowing.

Finally, let’s be clear: the SLR is supposed to be a constraint on a bank’s growth in relation to its capital base, so to some extent, Quarles is criticizing the SLR for doing its job. Notably, when it kicks in, big banks cannot get bigger without raising more capital, something they are typically loath to do.

Jamie Dimon, Chairman and CEO of JPMorgan Chase, attends a meeting hosted by US President Joe Biden with business leaders about a Covid-19 relief bill in the Oval Office of the White House in Washington, DC, February 9, 2021. (Photo by SAUL LOEB / AFP) (Photo by SAUL LOEB/AFP via Getty Images)
Jamie Dimon, Chairman and CEO of JPMorgan Chase, attends a meeting hosted by US President Joe Biden with business leaders about a Covid-19 relief bill in the Oval Office of the White House in Washington, DC, February 9, 2021. (Photo by SAUL LOEB / AFP) (Photo by SAUL LOEB/AFP via Getty Images)

That said, it is true that reserves in the banking system have grown dramatically, a byproduct of the Fed’s massive purchases of U.S. government securities since the pandemic began. It does so by purchasing them from the securities affiliates of big banks. The proceeds are then deposited into the banks’ reserve accounts. These reserves have grown from less than $2 trillion prior to the pandemic to nearly $5 trillion today, and may go substantially higher if Congress passes another $1+ trillion dollars in spending on infrastructure.

This is at the core of the argument put forth by Quarles, who said the post-pandemic reserve levels are “a wholly different situation than the leverage ratio was originally calibrated for.”

But this problem could be better addressed by removing only reserves from the SLR and raising the minimum ratios so that there is no net decrease in the total amount of capital these banks are required to have. This approach would not weaken the capitalization of the banking system, while giving banks expanded capacity to support monetary and fiscal stimulus.

And it would not undermine the utility of the leverage ratio as a backstop to other “risk-based” capital rules. These rules proved to be unreliable during the 2008-2009 financial crisis, and while they have been strengthened since then, they cannot be trusted to fully capture all risks which could undermine bank solvency. They are backward looking in that they are modeled based on imperfect analysis of how various assets have performed over time.

They also do not capture new and emerging risks. For instance, these rules, as well as the Fed’s annual stress tests, do not address financial risks associated with climate change. As the Financial Stability Board, a global regulatory organization which Quarles chairs, and many others have recognized, climate change poses serious threats to the stability of the banking system. Similarly, cryptocurrencies, a rapidly growing asset class, do not receive capital treatment under the risk-based rules. The unknowns around climate risks and cryptocurrencies exemplify another advantage of a strong leverage ratio: it protects against new risks which regulators do not yet fully understand, much less evaluated and quantified.

Quarles is an intelligent, thoughtful regulator. But if anything, we need more capital in the banking system, not less.

Removing reserve deposits from the SLR, while raising the minimum ratio, would adequately address his concerns without compromising system resiliency. There are so many unknowns facing the financial system today: will increasing consumer price inflation eventually force a rate increase, whether by the Fed or investor demand? If so, what will be the impact on bond markets and the ability of over-leveraged companies to refinance their debt? Are ever escalating prices for equities, commodities, home prices, etc., sustainable? What happens if and when they correct? What are the implications of the dollar’s devaluation? Many of these issues are a byproduct of Fed monetary policy. But as the Fed does not want to raise rates to address them, it should be looking to make more muscular use of its supervisory tools. These are forward looking risks that should be priorities for the Fed. Let’s put the SLR issue to rest.

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