What the Fed Should Do About Banks’ Capital Problem

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The coronavirus pandemic is reviving a perennial challenge for U.S. financial regulators: how to ensure that the country’s largest banks can support the economy during times of financial stress by extending credit to households and businesses.

The best answer, as always, is to insist that they’re strong enough to handle the unexpected. Regulations are in place to do this. Recently, though, a complication has arisen. 

On the whole, the banks are doing fine. Thanks mainly to the Federal Reserve’s actions to prop up asset prices, they’ve avoided big losses and in many cases have thrived. Even so, the Fed’s efforts to keep money flowing to people and businesses have collided with a regulation intended to make the financial system more resilient.

Known as the leverage ratio, this rule stipulates that banks must have $5 in loss-absorbing equity capital for every $100 they hold in loans and other assets. Unlike other capital requirements, this ratio doesn’t differentiate assets by risk. Even the safest of assets, such as Treasury securities and the reserves that banks deposit at the Fed, count toward the total. That’s because the leverage ratio is meant as a back-up for the rules that do take account of risk — ensuring, in effect, that banks can’t game the risk-weighting system in a way that compromises their safety.

The problem is that banks’ assets have ballooned during the pandemic. The Fed has bought vast quantities of securities, flooding the markets with cash, which in turn shows up as bank reserves. At the same time, the government has borrowed trillions to pay for pandemic relief, adding to the banks’ holdings of Treasury securities. The concern is that to avoid breaching the leverage limit, banks might have to curb their lending and deposit-taking — an outcome that would undermine the recovery.

It would be wrong to conclude from this that the leverage rules are too strict. Capital regulations are supposed to ensure that banks build up ample buffers, which they can draw down in times of crisis without breaching minimum requirements. But the banks have chosen (and have been allowed) to operate too close to the line.

Before the pandemic hit, the four largest U.S. banks — JPMorgan Chase & Co., Citigroup Inc., Bank of America Corp. and Wells Fargo & Co. — had a weighted average leverage ratio of 6.5% equity-to-assets, just 1.5 percentage points above the 5% minimum. As a result, the subsequent asset expansion, which moved their ratios by only a bit more than a percentage point, was enough to take some to the limit.

This shortage of capital has left regulators scrambling for a solution. From July through December last year, they forbade the banks to reward investors with share repurchases, which deplete equity (some mild restrictions remain in place through June this year). And from April through March of this year, they offered the banks a reprieve from the leverage ratio, temporarily exempting reserves and Treasuries from the calculation. Last week, the Fed announced that it would allow this exemption to expire as scheduled — just as the Treasury Department is about to add another $1.5 trillion to bank reserves, by spending down funds it accumulated to execute government relief packages.

If nothing else changes, this could actually force some big banks — primarily JPMorgan Chase and Citigroup — to cut their lending even as the Fed’s monetary policy is pushing them to lend more.

What to do? Regulators first need to renew the temporary ban on share repurchases. JPMorgan, for example, has announced plans to spend $30 billion on buybacks this year, an amount that (all else equal) would reduce its leverage ratio by about 0.7 percentage point. Next, temporarily extending the exemption for reserves might also make sense (even though it runs the risk of encouraging banks to hold reserves instead of going out and making loans). Exempting Treasuries, on the other hand, would be unwise. It would allow banks to make leveraged bets on the securities, creating risks that the rest of the regulatory system is ill-equipped to control.

Beyond the short term, the answer is more straightforward: insist on adequate capital buffers. Regulators should require banks to raise more loss-absorbing equity in good times, so they’ll be better prepared for the bad. The Fed should modify its stress tests to take into account the way banks’ balance sheets can grow during periods of financial stress, so that the buffers will be bigger before problems arise, and a minimum leverage ratio can be restored as a firm requirement.

Two main points are worth underlining. The right amount of capital is significantly higher than what banks have now. And monetary policy works better when banks are well capitalized. If banks start accumulating equity as the economy recovers, regulators will have less need for ad-hoc fixes next time around.

Editorials are written by the Bloomberg Opinion editorial board.

©2021 Bloomberg L.P.

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