Buy the People: Two visions, one rule – How Basel injected populism into bank capital

The most important topics and the most influential voices, leaders is a forum where industry experts and innovators share their experiences and perspectives on business critical issues. This is content that drives decision-making. Join the conversation today at americanbanker.com/leaders. Banks and regulators are often at odds, so it's no surprise that they're currently fighting over new bank capital rules. Ibrahim Asanto-Sane, who covers the FDIC, OCC and bank regulation for Americanbanker, had a question, "Why do both banks and regulators seem to think they're on the side of the little guy?" I'm Hana Schoenberger, Editor-in-Chief of Americanbanker, and this is Bankshot. It was Sunday night, I'd gone out to dinner with my nephew, and I came home, turned on the football game to see how my fantasy team was doing. This is Aaron Klein. I'm Aaron Klein, Miriam K. Carlinner's chair and senior fellow in economic studies at the Brookings Institution. Before joining the Brookings Institution, I was deputy assistant secretary of the treasury under president Obama, and chief economist to the Senate Banking Housing and Urban Affairs Committee under chairman Christod and Paul Sarvagan. So I tuned it on, linked in the game, and was only mildly paying attention to the game looking at my phone when all of a sudden. Getting ahead isn't easy in this economy, but millions of Americans are still trying. But now, the Federal Reserve wants to impose unnecessary capital rules, the raised costs for everything we buy. Making harder to buy home. And I looked up and was stunned to find this important but generally obscured topic on national television in the middle of the Sunday night football game. So I happened to tweet about how insane I thought that was, working life colliding, which caught the attention of a reporter, and the story kind of snowballed from there. For the record, I did win my fantasy game, although not the league this year. The topic he's referring to is the so-called Basel III Endgame, a set of regulatory proposals that came out last year, and that banks have opposed more intensely than almost any other regulatory action in recent memory. Since their emergence in the wake of the 2008 financial crisis, the Basel III Accords have served as an important set of minimum regulatory standards that signatory countries, which includes most of the developed economies in the world, have a great to observe. Most of the biggest features of the Accords have been implemented in fits and starts over the last 15 years or so. But the minimum standards for operational, liquidity, and credit risk were made incomplete in the US. That is, until last July, when the Federal Reserve, Office of the Comptroller of the Currency and Federal Deposit Insurance Corporation, issued a proposal that would raise capital requirements for the largest and most systemically risky banks, considerably. The question of how much capital a bank must hold to ensure its solvency without keeping it from making loans is not empirically noble. It is a judgment, and different regulators across different administrations have reached different conclusions about what the numbers should be at different times. But the Basel III Endgame proposal has reanimated this to be in a new way, pitting the populist interest of ensuring that we never have another 2008 financial crisis against the populist interest of ensuring that consumer lending is plentiful and consumer prices are reasonable. But how real are those risks? And why is bank capital being framed in such populist terms? [Music] From American banker, I'm Ibrahim Asanto Asane, and this is Bank Shot, a podcast about banks, finance, and the world we live in. Bank capital is hardly a kitchen table issue. Most people can live their entire lives without knowing what it is or how it works. So I asked an expert to explain it. I'm Peter Conti Brown, I'm an associate professor. It's an interregulation at the work in school of the University of Pennsylvania. And here I do research on banking, central banking, banks supervision, financial history, and related topics. In the jargon of banking, bank capital can refer to a variety of different things, but its central purpose is to speak to balance sheet regulation. And this bank capital is bank equity capital. Yet of all the app that has track out all its liabilities when that's the shareholder capitalization. At the highest and broadest and fifth bank capital, I'll try to understand exactly how banks are funded. But another way, and again, in the broadest terms, bank equity capital is what's left over if you subtract its liabilities, think deposits, money the bank is borrowing from you and me, from its assets, namely the loans that generate the bank's revenue. And in the United States, banks have to have more assets than liabilities. And not only that, banks have to have certain kinds of assets and liabilities. And the reason this is so important is because bank debt, we don't generally think of it's easy come easy go. It's relatively easy for banks if they're willing to pay for it to get liabilities, whether that's from depositors, running money the banks by opening bank accounts. Or by issuing debt into capital markets, they're the legal obligation to snoeciate with bank debt. Relatively easy to come by because they're relatively easy to redeem and different kinds of debts are going to be treated differently, of course. But that's the basic philosophy. And the easy come part makes it so easy go is the part that regulators really worry about. But the sudden you have all of the debt of a bank rapidly departing that institution that has a quick shift from a liquidity crunch to a salvency crisis to a failed bank. You add up a few failed banks and all of a sudden we've got a financial crisis on our hands. And this broad concept of bank capital is not a new idea. Capital requirements for a long period of all this back, the Alexander Hamilton even before that. I mean the basic principles and for lots of these of fractional reserve banking speak to the general realization that having a well capitalized bank means that it can engage in the business of banking well enough to survive. The long history of bank capital, which is very interesting begins with no capital regulation. My name is Simon Johnson. I'm a professor in MIT in the Sloan School of Management. I'm also the co chair of the CFA Institute Systemic Risk Council. And I was previously the chief economist at the international monetary fund. You just say look, let the banks decide for themselves. And in fact a lot of banks had 50% 50% capital, a huge amount of equity, relatively because there was no, you go back to the 19th century, there was no safety net. With the creation of the Federal Reserve in 1913 and particularly the advertive deposit insurance in the 1930s, you've got these very important back stops. And you know we can argue about the value of the backstop and when the bank stop is manifest and whether any of the insiders face costs, but there is a backstop. And that means that the cost of a bank failure if it does fail will be born by somebody else could be people who stand distance and pay fees into the deposit insurance fund for example, or it could be spread more broadly onto the taxpayer through various mechanisms. So in that world, unless the world that we live in in the world that everyone in the industrialized boxes is lifted since the 1930s and 1940s in that world, the view is that banks should be required to have these buffers of capital. So they suffer some losses. It doesn't initially become a soul as a crisis doesn't get pushed over to also insurance or the central bank. The capital definition we've just described is what is known as a leverage ratio. It's an equation where debt divided by assets equals capital and regulators use it as a binding capital constraint. But the problem with the leverage ratio is that it treats all assets and debts the same when in reality some loans are riskier than others and some funding sources are riskier than others. Holding a treasury bond yielding 3% interest has less risk than alone to build a soul from mine and the Amazon rainforest that might bear at 11% interest. But if all assets are treated the same, banks will naturally gravitate toward more high yielding and therefore riskier assets. To account for the inherent risks where absence of risk associated with certain assets, banks supervisors all over the world have adopted risk weighted capital standards that require more or less capital to be allocated to offset losses. And in 1987, the Basel Committee on Banking Supervision and International Consortium of Banking Regulators based in Switzerland came up with the first set of international standards for how risk-based capital ought to be applied later revised in 2005 as Basel II. But risk-weighting brings up its own set of challenges. The problem is the models are always wrong. Some prime mortgage is not risk-y if diversified geographically. Investing in low percentage rate treasuries, not risky if you're SVB. The people that are in love with risk-based models are in love with the models and aren't critical and don't acknowledge the models fail. The people who love simple leverage don't acknowledge the adverse consequences of that. In an American bank or bank think piece, I analogized it to eating with chopsticks. If you have two chopsticks you can eat elegantly and if you have one you're just stabbing at it. If you're really comfortable with the dual capital system, then at some points in the business cycle simple leverage will bind and at other points risk will bond. But what we found in my 20 plus years is the people who decided who are in love with risk-based models. in camp one, get mad when the other camps is the binding constraint. That is a many decades conversation. The way that ended up actually before the financial crisis of 2008 is quite interesting and instructive. The Europeans had rather bought into the idea that the banks were sophisticated, clever, they had very smart models. And some of the European banks in 2008 had only 2% capital, 2% equity, 98% debt of a liability side. And at least banks were obviously in massive trouble. That was the Basel-Tufrein way. The US had dragged its feet about adopting that because in particular the FDIC led by Schiller Bear was not convinced the banks were so very smart and not convinced that the way risk weights were proposed in the Basel-Tufrein was a good idea. So the US had not fully adopted Basel-Tufrein in retrospect, that's a good thing because US banks constantly had higher capital, less leverage, more equity relative to that. These roles differ ways of saying the same thing. And that was helpful when really bad things happened in 2009. The 2008 financial crisis brought the shortcomings of overreliance on risk-weighting home in stark relief. And the Basel committee quickly developed another set of standards known as Basel 3. And at that time regulators were highly incentivized to come up with something that could credibly ensure that another calamity on the scale of 2008 wouldn't happen again. After 2008, a first was a global thing which was that the bank regulators, including the United States, realized that the people running these banks, including very large banks, the largest banks, city group, bank America, they were all in trouble, largest UK banks and the large European banks as well. The review was that these banks and the people rather than not actually the masters of the university, they've made some pretty straightforward mistakes. They make mistakes because of the incentives that they face, not because they're bad and evil people necessarily, but just because they have an incentive to take a lot of risk and to have small amounts of equity relative to large amounts of debt. So there was a big shift in the thinking of regulators and everyone in that regulatory community. The Obama administration had a completely different context because the banks couldn't no longer argue that they were well capitalized. It's like 2008. My national crisis, QED, the bank system was inadequately capitalized. I've seen no serious person, including inside the banks, argued that that wasn't so. I'm not good here. The banks failed at such a spectacular rate because they were insufficiently capitalized. Considering the Obama administration, you certainly saw the implementation of different capital requirements than had preceded it. That was in part because the capital requirements that came out of bubble too had so few constraints to them. The issues that Basel III intended to tackle was the treatment of certain kinds of risk, namely operational, credit, and market risk, and what kinds of models may be used to establish those risk ratings. But whereas much of the Basel III accords have been implemented, those final elements were made incomplete. And so it was, through the end of the Obama administration, where the Fed started for the first time to asking the questions like, "Did you go too far as there's too much constraint on banks?" We had a relative inemic economic recovery, and there were people who wondered whether any regulation was something to do with this, including some Obama-plaintewist. And President Hampton was inaugurated in sort of making appointments in these conditions, one of those important, part of the most important. That he made was Randy Quarrels, the first vice-chairperson of the Fed. He came in, I think, ideologically disposed to the idea that we had over capitalized the system, that we needed to remove some of those constraints. And his view was limited by the passage of the made-to-peace of legislation, the first piece banking legislation that followed the passage of Dodd-Frank, and that was to vote in the Senate Bill of 2155. It asked the bank regulators to tailor capital requirements and all others. And so they did one of the reasons that we're talking still about, on the three, despite the fact that we are 13 years after its passage is because basically the current administration, the final implementation rules, was mostly postponed. With President Joe Biden was inaugurated, and Michael Barr confirmed as the Federal Reserve Vice Chair for Supervision, it was apparent that the government had been in a state of parent that the postponement was at an end. But the collapse of Silicon Valley, signature bank and fresh republic last year, created the conditions for regulators to go big, and they did. Enter Basel III Endgame, after this quick break. Get big ideas and must-read stories delivered to your inbox every morning with American Bankers' daily briefing newsletter. Join a community of banking and financial professionals who rely on American Banker to analyze complex issues, keep up with breaking news, and help advance their careers. Sign up for free at americanbanker.com/daily-briefing-signup Last year, the Fed, FDIC and OCC issued a proposed rule to satisfy those final aspects of the Basel III Accords, which the regulators themselves have dubbed Basel III Endgame. The proposal is actually a couple of different proposals, but the ones we're concerned with would replace bank's own risk-weighting models with one devised by the regulators. That model would also account for available for sale securities and calculating capital and expand the applicability of the supplemental leverage ratio and counter cyclical capital buffer and increase capital retention for certain activities. It's a big rule that does a lot of things, but the upshot is that the biggest banks by the regulators' own estimation would see their risk-weighted capital requirements go up by about 16%. And banks, many of which estimate the costs of the rule as far higher than the regulators, have decided not to take this long down, as evidenced by the football ads we discussed earlier. I have certainly throughout much of my career been very critical about the Basel framework. And I believe the Basel framework was a contributor to the problems since 2008, and while there have been modest improvements, I'm certainly the view that the status quo is not good. So I'm at first very sympathetic to what I think the vice-chair bar and the Fed, and as well as the other regulators that I've seen others are trying to achieve. That's Mark Calabria. Mark Calabria, I'm currently a senior advisor at the Cato Institute, which of course is a nonprofit nonpartisan. Thank you, and Washington, DC. I do economic strategy at the Cato Institute. Prior to that was a director of the Federal Housing Finance Agency. Prior to that was chief economist for vice-president Pence at the White House. I don't think our system is solid and solid and where it needs to be. I don't think conscious of some of my friends in the district. I don't think banks are overcapitalized. And in fact, I think most of the banking system is still highly leveraged. So for starters, I'm pretty sympathetic to the argument for the Vizini Basel. And obviously there were pretty severe problems. If our banking system could not withstand uninsured depositors in a regional bank, taking a 10% haircut as they would have an SVP, then they're clearly problems with the system. So using that as a point of departure, obviously it's a very long complicated process. I feel like it's overly complicated. I feel like there are a number of issues with the don't deal with the underlying problems, certainly not the underlying problems that got Silicon Valley back in trouble. And I do worry that the distortions in unintitated consequences were outweighed the good. So at the end of the day, and I think the process is not really built on broad consensus among regulators. So me having looked through it, having heard a lot of common theory, even though I think that the regulators do need to revisit MopDate Boss, or I don't think this is the right approach. I think there are elements of it that are the right approach. And I think this should go back to the join board. But again, I would emphasize there is a need for something like this. The gist of the bank's public opposition to the Basel 3 endgame proposal is pretty straightforward. The rule will drive up costs and reduce our ability to take on risk, making services more expensive and loans fewer and more expensive. That in turn will increase costs for consumers. Make it harder to buy home. Send a kid to college. Have something to retire on. Harder for small businesses to borrow, expand, and access credit. Americans don't want special favors. They just want a fair shot. But there's more to exactly how those standards might raise costs. The basic idea that the banks raise comes in two flavors. The first is, all kinds of reasons, banks prefer funding themselves to get the tax equities. The most common reason they offer is that equity is expensive. They will take a pile of assets and say, "Sharehold, we buy this pile of assets for $100 and sharehold, they say, no, we will take that same pile of assets and pay $60 for it." That makes overvalue their assets relative to the market. That's one version of that. They don't want to raise that money from the equity market because that means that they're not going to raise as much money. Another is that shareholders are not going to be super eager to see their own shareholdings be diluted. Some of these shareholders of banks are now in order to get you more equity. You're going to have dilutes, the creepiest shareholders. The all shareholders are going to look at this somewhat with the Himalayan because they're going to say, "We don't want to be shareholders of an organization constantly diluting the value of our shareholding." So they might be more reluctant there. Another reason is because shareholders have become habituated at the term of use in economics. There's the habit of investing in certain asset classes and certain particular uncertainties such as we see in banks and now it's going to be let that be, they just think that they're going to be sure dividends paid because they're having to use that money in other ways. Another concern with the proposal is that lending may not go away, but instead will be forced out of banking altogether and into the arms of more lightly regulated dawn banks. Some concern about here is this risk being pushed elsewhere, which may leave the overall system less safe. This was a big concern. I think one of the contributors to the problems in 2008 was there really wasn't an approach by regulators to simply say, "I'm only responsible for the risk of the institutions I regulate and wherever else it goes, somebody else is problem." And of course the entire FSOC framework at a Dodd-Frank is supposed to make them sit across the table from each other and think more holistically about the system. And so again, I think that's something that has been lacking in this proposal of where is this risk going to go. I think there's somebody in underlined assumption that, "Yeah, we'll just stay with banks." Well, will it? And I think that that's an open question we need to have. But those increased costs are not being imposed for no reason. The public gets something in exchange and that is a more resilient economy whose lenders are less likely to fail when times get tough. Bank capital is an effective tool for ensuring that banks are resilient, as banks themselves evidently believed when they retained 50% capital before there was a fad or bank regular is at all. First of all, better capitalized banks don't collapse and therefore are more resilient over the business cycle and financial cycle. So therefore you have strawberry credit over the cycle. That is point number one. Second point is, in case anyone's forgotten or as you recently noticed, credit conditions in this country are primarily determined by the Federal Reserve. But you need to have tight monetary policy or no monetary policy. And if there were the case that, which it wouldn't be, but if there were the case that bank credit were contracting in a way that was counter to what the Federal Reserve was trying to achieve at the macro level, we're obviously going to have considerations about output employment and innovation. Federal Reserve would lean the other way with monetary policy. So I understand in a sound awkward for me to say this and I promise everyone I do really say this in public and to the faces that people make their statements. And those claims from the banking lobby are not only completely erroneous in the odds with the facts, actually don't make any sense when you consider how the economy works. There's a thesis among industry that higher bank capital means less profitability. And there's a theory by some academics and others on the left that kind of bank capital increases don't have any cost. I find both of them lacking critical analysis. It's hard to imagine raising capital for certain types of loans and certain products and not others has no cost. It's also hard to square the reality that lower capitalized banks have not been profitable on a global basis over history. European banks have often, for most of the 20th century, lower capital requirements and we're less profitable than American banks. And some of the lowest capitalized banks in America were the ones more likely to fail than those with better capital. This brings us to the central question, which is this. How can populism favoring the people over elites beyond both sides of this debate over a relatively obscure regulatory proposal on bank capital? There are a couple things that are different, right? One is the capital requirements seem very large. There's a big increase in capital coming from these new rules according to the banks. And they're happening during a period of relative economic strength. The history of financial regulation in this country is that during good times there's deregulation and during bad times there's regulation. And so it's unusual for higher levels of capital regulation to occur during an economic recovery absent of banking crisis. Around Dodd-Frank there'd been a massive financial collapse. And everybody had a moment where they acknowledged the failures of the deregulatory regime that preceded it and the need to do something different. There were legitimate questions about how far to go, what to do differently, but there was a broad agreement that we needed more capital, more liquidity, and broader speaking more regulation. Now what's different today is there has been no financial crisis. There were problems at a few banks like Silicon Valley and first Republic in the spring, but that was not a systemic event. Nor was that necessarily the result of inadequate levels of capital. So I think what's different here is you're seeing a new regulatory push by the bank regulators to increase capital during broadly speaking economic good times, absent of financial crisis. And you're finding an industry that is on stronger footing with the American public to say, wait a second, we don't think this is a good idea. There has been a pop-up settlement and that was in the Trump rollback of regulations where it was claimed that this would make the banks better able to make American data, I suppose. And it's very interesting if you go back and look at the record of a sedative hearing in 2015, which I testified actually on the rules for regional banks. There was a letter submitted to that here. This obviously before Donald Trump was elected, but this view is what got picked up and implemented in a sense in the Trump era rollback and what the Fed did with regard to the distribution of the era. So this letter was from Greg Becker, who was then the CEO of Silicon Valley Bank. And actually he was still, he was, the CEO of Silicon Valley Bank last year when it failed. And the letter said, this is very close to a quote, Silicon Valley Bank like other of mid-sized banks does not pose any systemic risks. The actual quote was, SVB, like our mid-sized bank peers, does not present systemic risks. Well, I think we learned that that was wrong, right? It was wrong in 2015 when he said it was wrong in 2023 when the FJC Treasury and the Federal Reserve invoked the so-called systemic risk exception to protect all the unashored positives in Silicon Valley Bank. So yes, there is a pop-up list wave. As people try to press those buttons, underlying it is just pure and straightforward greed that people running these banks want to run more leverage institutions because they get the upside and someone else has to worry if it's, when there's a big downside. Lemon socialism is another term for it, every month. So these people just want to line their own pockets and walk away and think about a slide which Mr. Becker did, by the way. I see in this fight a really poor difference in the world, that makes it so that those who see the issue with crystal clarity are skipping some steps. And I say that on both sides. The through line between the current levels protect the economy from recession and the proposed levels will take us into recession is jagged and dotted. And I think acknowledging that, that you're making a bet about the future with high confidence but low evidence is important. And the other side is too that this change in capital will prevent financial crises or we'll go a long way to bring more financial crises without having corresponding illiterious economic effects. That's also jagged and dotted through lines. And appreciating that just a little, uh, uh, uh, ETS or word that by share bar likes to use a lot. But a little bit of regulatory humility is that recognize that here we're looking at this not because there is any evidence that we can offer that proves our case. But because we are evaluating probabilities of different outcomes differently, that impetredance is truly at the core of our differences around capital regulation. That is, we have different reasons about how regulation works and how it doesn't. To me, I mean, you know, where I would say is to say, can we come up with a regulatory system that has more capital, but lower some of the compliance costs in tries to be simpler in a way that perhaps at least some of the industry can accept. But that said, you know, you do have a more hostile environment. I mean, it's an interesting question in that, you know, the administration's approach to, you know, SVB was to try to move past that pretty quickly. So I mean, but again, they were kind of in a box. I mean, you couldn't at the same time try to capitalize on that without, you know, suggesting that you members of your administration were asleep at the wheel or, you know, are focused too much on the rescue of large tech companies that have the deposits. So I think they they made perhaps the right call, which was to move on from those bank failures as quickly as they could, but the cost of that was they never created a public demand to do anything else. And that's the trade off here. And so it is unfortunate, again, I worked with the Banking Committee going into 2008, I can tell you, you try to get anybody to care about problems before that happened is very hard. There's no constituency for an if financial stability is the sad truth. And the pressures are always going to be, you know, to kind of erode that, especially when people feel like the economy is going well. And certainly, you know, there's always short-sightedness from both industry and from the regulators. But you know, there is a change in dynamic. And so the industry has a stronger hand than they had in 2010, because again, the public is less concerned about banking issues right now. This episode of Bank Shot was reported and written by Ibraima Santo Sane and edited by John Helman. Our audio producer is Kelly Malone Yee, special thanks to Mark Calabria of the Cato Institute, Aaron Klein of the Brookings Institute, Peter Conti Brown of the Wharton School of the University of Pennsylvania, and Simon Johnson of the MIT Sloan School of Management.