Fed's Bank Capital Rules Need More Than Fine-Tuning

(Bloomberg View) -- Having spent nearly a decade crafting new capital requirements to bolster the resilience of the country’s largest banks, the U.S. Federal Reserve is getting ready to do some fine-tuning. The rules can certainly be improved -- but what’s needed is more than tinkering around the edges.

The Fed has two main tools to ensure banks have enough equity capital, the bedrock financing that lets them absorb losses and continue lending in difficult times. It sets minimum levels, and it conducts annual stress tests to see whether the thresholds would be breached in a crisis. Its new idea is to link the two together -- using the tests to help adjust the levels.

Currently, if a bank flunks a stress test, the Fed restricts how much equity can be given back to shareholders -- in the form of dividends and share buybacks -- until the bank is better capitalized. Under the Fed’s new proposal, banks that suffered bigger losses in the tests would automatically face higher capital requirements, hence stricter limits on their payouts.

This is a good idea as far as it goes. Banks that take on more risk need more capital to absorb the potential losses. Together with other tweaks to the stress tests, the proposal might boost some of the largest banks’ capital requirements by some tenths of a percentage point, while reducing requirements for smaller banks that don’t have global trading operations.

Such fine-tuning, however, fails to get to grips with the bigger problem. Taken together, existing capital requirements and stress tests still aren't enough to prepare banks for a real crisis. As soon as people start to think a bank is going bust, it’s doomed. So it needs enough equity to absorb severe losses and continue operating. The largest institutions currently have as little as $6 in equity for each $100 in assets. Research by the Minneapolis Fed suggests that they would need more than twice that amount to make disaster acceptably unlikely.

The Fed’s plan to link capital and stress tests does little to address that -- and another new proposal moves in the opposite direction. Regulators want to weaken the so-called supplementary leverage ratio, a backstop designed to make sure banks have a minimum amount of equity no matter how safe they believe their assets to be. The aim is to tailor this requirement to banks’ systemic importance -- again, a good idea in itself -- but the effect will be to reduce required capital at some of the country’s largest depository institutions by an estimated $121 billion.

Regulation should be smart and no more burdensome than necessary. The Fed is right to seek improvements in an unduly complex system. But these plans miss the most important point: The goal should be to ensure that when the next crisis comes, the financial system will be a source of strength, not fragility.

--Editors: Mark Whitehouse, Clive Crook.

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