Fed Vice Chair Michael Barr Calls for a Tougher and Holistic Review of Bank Capital Rules

  • Source: federalreserve.gov

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In a speech hosted by the Bipartisan Policy Center, the Fed Vice Chair Michael Barr reinforced the need to strengthen the bank capital standards with the sole objective of enhancing the resilience of banks and the broader financial system at large.

Enhanced capital rules outlined below apply to banks and bank holding companies with $100 billion or more in assets. Proposed enhancements to the capital rules would require banks with assets of $100 billion or more to account for unrealized losses and gains in their available-for-sale (AFS) securities when calculating their regulatory capital. This change would improve the transparency of regulatory capital ratios, since it would better reflect banking organizations’ actual loss-absorbing capacity. The expanded scope is deemed appropriate for two reasons:

  1. proposed rules are less burdensome for banks to implement than the current requirements, since they don’t require a bank to develop a suite of internal credit risk and operational risk models to calculate regulatory capital.
  2. recent experience shows that even banks of this size can cause stress that spreads to other institutions and threatens financial stability.

Holistic Review of Capital Requirements

  • Fed will be pursuing further changes to regulation and supervision in response to the recent banking stress addressing the liquidity risk, interest rate risk, incentive compensation alongside enhancing the speed, agility and force of the Fed’s supervision
  • Emphasis on multiple ways measuring the risk including both the risk based and non-risk based measure to managing the overall risk of the banking system supplemented by stress testing mechanisms to measure the bank resilience against a hypothetical shock.
  • Barr underscores the importance of updating the existing risk based measure to better capture the credit, trading and operating risk. The updates should be consistent with the Basel international capital standards.
  • Barr points out the need for stress tests to evolve to better capture risk by including a wider range of risks complimenting the risk based supervisory framework.
  • Michael Barr recommends improvements around the measurement of system risk indicators under the G-SIB surcharge framework to reduce the “cliff effects” and make it more risk sensitive to reflect the bank’s risk profile.

 Basel III Endgame

  • Lending activities – Proposed rules to end the firm’s reliance on internal measure of risk due to several deficiencies in the use of internal models including underestimating the credit risk to lower the capital requirements. More in favor of standardized credit risk measurement approaches that is more transparent and consistent in approximating the credit risk.
  • Trading activities – Firms would also be required to model risk at the level of individual trading desks for particular asset classes, instead of at the firm level. The proposal would also introduce a standardized approach that is well-aligned with the modeled approach, for use where the modeled approach is not feasible. Requiring banks to model market risk at the level of individual trading desks better reflects the observation that correlations across risks can change dramatically in times of stress. proposal appropriately charges more capital for positions that are less liquid, in order to better capture the risks of illiquid trading positions.

 Operational Losses

  • Replace internal models with standardized measure for operational risk covering trading risk losses or litigation expenses. The proposal would approximate a firm’s operational risk charge based on the firm’s activities, and adjust the charge upward based on a firm’s historical operational losses to add risk sensitivity and provide firms with an incentive to mitigate their operational risk.

Changes to the Stress Test to Improve Risk Capture

  • While Barr believes that the existing framework for stress testing generally remains sound, he underscores the need to review the global market shock and the stress test’s approach to estimating operational risk so that they provide a complementary lens to the risk-based standards on market risk and operational risk, respectively. Fourteen years of stress testing, and the real-life surprises during that time, including the pandemic and the bank stresses this spring, have made it clear that stress tests need to be stressful to adequately prepare banks for unanticipated events. The stress test should evolve to better capture the range of salient risks that banks face. In addition, the Board could use a range of exploratory scenarios to assess banks’ resilience to an evolving set of risks and use the results to inform supervision.

Minimal Adjustments to the G-SIB Surcharge to Improve Precision

  • Technical adjustments are proposed to the calculating the G-SIB surcharge
    • The proposal would measure on an average basis over the full year the indicators that are currently measured only as of year-end. This change would more accurately reflect the systemic risk profile of a firm and reduce incentives for a firm to reduce its G-SIB surcharge by temporarily altering its balance sheet at year end through so-called “window dressing.”
    • The proposal would reduce “cliff effects” in the G-SIB surcharge by measuring G-SIB surcharges in 10-basis point increments instead of the current 50-basis point increments.
    • The proposal would make improvements to the measurement of some systemic indicators to better align them with risk. These changes would ensure that the G-SIB surcharge better reflects the systemic risk of each G-SIB.

Long Term Debt

  • Apply a long-term debt requirement for all large banks with $100 bn or more in assets. Long-term debt improves the ability of a bank to be resolved upon failure because the long-term debt can be converted to equity and used to absorb losses. Such a measure would reduce losses borne by the Federal Deposit Insurance Corporation’s (FDIC) Deposit Insurance Fund, and provide the FDIC with additional options for restructuring, selling, or winding down a failed bank

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Kishore Ramakrishnan

Kishore Ramakrishnan is Managing Director, Capital Markets Advisory at Treliant. He has over 24 years of global industry and consulting experience across the banking, capital markets, asset, and wealth management businesses.