As federal regulators prepare to propose new capital standards this summer, a debate has emerged over their timing and potential impact on the real economy
Federal Reserve Chair Jerome Powell and Federal Deposit Insurance Corp. Chair Martin Gruenberg both confirmed last week that a proposed rule for the final implementation of the Basel III international regulatory framework is imminent and signaled that it will include greater capital requirements for the country's largest banks.
In response, bank advocacy groups and some lawmakers have argued that rolling out new requirements — especially those that increase capital obligations — will have a swift impact on bank balance sheets and their willingness to lend. Such a shift, they warn, could put further strain on an already weakening economy.
"The risk that capital requirements start to take effect and start to crimp lending activity at a time when we're facing economic headwinds is significant, in my opinion, and only continues to grow as the data makes itself evident," said Sean Campbell, chief economist and head of policy research at the Financial Services Forum, a trade group representing the largest banks in the country.
Regulators waved off such concerns last week, noting that long-term regulatory concerns outweigh near-term economic uncertainties. Powell said banks will have "some years" to adjust to new policies, allowing them to do so with minimal disruption to their lending activities. Gruenberg said holding more capital could better position banks to support the economy in a downturn.
"History has proven that insufficient capital can lead to harmful economic results when banks are unable to provide financial services to households and businesses, as occurred during the 2008 financial crisis," Gruenberg said during a speech last week. "Ensuring adequate amounts of bank capital provides a long-term benefit to the economy by enabling banks to play a counter-cyclical role during an economic downturn rather than a pro-cyclical one."
By the letter of the law, regulatory change is a slow process. Once the Fed, FDIC and Office of the Comptroller of the Currency release their proposal for the Basel III endgame sometime in the coming weeks, it will be open to months of public review and commentary. After that, regulators will spend several more months incorporating that feedback before releasing — and ultimately voting on — a final rule. Once adopted, the rule's requirements will likely be phased in gradually over several years.
But, in practice, the adaptation process can play out much more quickly. A working paper published by the Federal Reserve Bank of Cleveland last year notes that many mid-sized banks changed their balance sheets to accommodate for the first installment of the Basel III framework years before they were required to by law — in some instances, changes were made before regulators finalized the language of the rule.
Jan-Peter Siedlarek, a research economist at the Cleveland Fed and one of the author's of the paper, said his study — which examined both small banks with $10 billion of assets or less and mid-tier banks with between $10 billion and $50 billion, just below the stress testing cutoff — found that banks that had ample warning that changes were coming their way, made those changes as quickly as they could.
"The key lesson that we want to get across in this paper is that, in a regulatory rulemaking process, the announcement of rules already matters. It's already an important part of what both financial markets but also the regulated entities are looking at," Siedlarek told American Banker.
Karen Petrou, managing partner at Federal Financial Analytics, said the process of investors responding to regulatory changes and banks responding to their investors has become a well documented cycle, especially under the post-Dodd-Frank regulatory regime.
"Investors are priced on a forward-looking basis, and they immediately run the numbers and price the new capital rules or new stress scenarios into their cost of equity," Petrou said. "That immediately changes the bank's strategic outlook. We know that because we see it year in, year out."
Campbell noted that in addition to pressure from investors, bank's also push one another to adopt policies promptly to avoid falling behind the pack.
"The competitive dynamic is such that you do not want to ever be the last bank to comply with changes to capital requirements, liquidity requirements or any other type of regulatory requirements," he said. "Complying quickly sends a strong signal to the market about your financial wherewithal, your strength and your resiliency, so there's a drive to comply as quickly as possible."
Powell, who testified in front of the House Financial Services and Senate Banking committees last week, acknowledged that some banks might already be adjusting their balance sheet in anticipation of regulatory changes. He also noted that he would factor in the potential economic implications of capital changes when voting this summer's proposal.
"Higher capital, you know, the benefit of it, of course, is to have stronger banks that can lend and maybe survive more kinds of crisis environments, but, you know, there are costs as well," Powell said in the House. "I think it's going to be, as always, a question of weighing and balancing those costs. That's what I'll be thinking about."
While pulling back on lending is one way for banks to raise capital, other options are less damaging to the real economy. Many banks are already increasing their capital holdings in anticipation of both a recession and more stringent regulations, according to an analyst note from Autonomous Research last week, and doing so "organically," meaning they are curbing stock buybacks and tempering expectations around dividends.
Some policy experts believe this is the most sensible course for all banks to take, if higher capital requirements come to pass. Dennis Kelleher, head of the consumer advocacy group Better Markets, called the argument that increasing capital requirements will hurt the availability of credit a "smoke screen."
"The only people who are really hurt by higher capital are bank executives. The lower the capital, the higher the leverage, and the higher their compensation," Kelleher said. "Their compensation is driven by return on equity, and equity is amplified by leverage. It's just that simple."
There are also questions about how quickly banks will be able to adapt to the specific changes set to be introduced this summer.
Patrick Haggerty, senior director at the advisory firm Klaros Group, said the nature of the Basel III endgame rules — many of which are focused on internal risk modeling — are nuanced and complex. Because of this, he said, banks will not be able to implement snap responses.
"They're going to need to put a project team together and spend a period of months trying to get their arms around what is changing and how it flows through to their regulatory reporting and the technology needed to run the calculations," Haggerty said. "That work is very expensive and resource-heavy. I can't imagine the banks are going to start to undertake that based on a proposal."
Siedlarek also noted that unlike the first phase of the Basel III framework, which had been well forecast based on its implementation in other jurisdictions around the world in a time of relative stability, the current proposals are subject to a higher degree of uncertainty. The failures of Silicon Valley Bank, Signature Bank and First Republic Bank this spring have raised a unique set of challenges with which the industry and regulators are still grappling.
"What happened in March was a change in the environment … the world before March and after March, I think they're quite different as to the extent to which banks are looking at their own industry and how they're going to position themselves," he said. "So, I do see the parallels [between the regulatory processes] but I also know differences, and so it's hard to see what's there."
