AFR NPR Risk Adequacy

Read PDF version here

February 28, 2011

Hon. Ben Bernanke, Chairman

Federal Reserve Board

20th Street and Constitution Avenue NW

Washington, DC 20551

Hon. Sheila Bair, Chairman

Federal Deposit Insurance Corporation

550 17th Street, NW

Washington, DC 20429

Mr. John Walsh, Acting Comptroller

Office of the Comptroller of the Currency

Administrator of National Banks

Washington, DC 20219

Re: Docket No. OCC-2010-0009 — Risk-Based Capital Adequacy Framework-Basel II; Establishment of a Risk-Based Capital Floor

Dear Chairs Bernanke and Bair and Acting Comptroller Walsh,

American for Financial Reform (“AFR”) appreciates this opportunity to comment on the Notice of Proposed Rulemaking regarding Risk Based Capital Standards: Advanced Capital Adequacy Framework-Basel II: Establishment of Risk Based Capital Floor (“Capital Adequacy NPR”).

AFR is a coalition of over 250 national, state, local groups who have come together to advocate for reform of the financial industry. Members of the AFR include consumer, civil rights, investor, retiree, community, labor, religious and business groups along with economists and other experts.

The Capital Adequacy NPR under consideration proposes rules for capital adequacy standards to ensure financial firms have adequate equity to absorb losses and maintain a reasonable level of leverage measured against both average total and risk weighted assets, with the goal of increasing financial stability and helping to prevent financial institution collapse. In particular, the NPR implements the statutory requirement under Dodd-Frank Section 171 (the “Collins Amendment”) that the capital requirements for bank holding companies and other large financial

institutions shall not fall below generally applicable leverage and capital standards established for insured depository institutions by the Federal banking agencies.1

In the area of capital adequacy, this requirement is one of the most important and clearest legislative directives in the entire Dodd-Frank Act. It is also particularly timely, as it addresses problems with the Advanced Approaches Rule (“AAR”) under Basel II that have been made very apparent by the financial crisis. We therefore applaud this proposal as a vital means of extending and augmenting the nation’s capital adequacy regime.

First, the proposal provides that the current capital adequacy requirements shall be a floor for capital adequacy purposes regardless of the outcome of the introduction of AAR. This is a prudent and critical measure, as the various Quantitative Impact Studies (QIS) have consistently found that certain Basel II approaches to determining capital risk weights could lead to substantial cuts in capital requirements at major banks. For example, the QIS 5 found that the largest banks using Advanced Internal Ratings-Based (AIRB) models would be permitted to cut required capital over 7 percent compared to current mandated levels, while some medium-sized bank holding companies could be permitted to cut over 20 percent.2 Regulators should not sanction lower quantities of risk capital held against risk weighted assets than had obtained before the financial crisis of 2008, when the government was forced to bail out financial institutions deemed too big to fail at taxpayer expense.

The lower levels of capital required under the AAR are symptomatic of deeper problems with the Basel II approach that this regulation will help to address. One of these problems is the pro-cyclical nature of capital requirements under Basel II. Because the IRB approach permits banks to align their asset risk weights with recent observed performance of that asset, Basel II risk weights will tend to be lower in good economic times and higher during recessions.3 This has the effect of lowering bank capital requirements in the upswing of an economic cycle and heightening them in downturns, thus encouraging over-lending in good times and economic contraction in bad. By instituting a flat limit on bank leverage that is not sensitive to the economic cycle, this rule should help to maintain a more consistent level of bank capital over the economic cycle.4

A second issue addressed by this rule is the inappropriate delegation of regulatory flexibility to private actors such as large banks’ internal risk management divisions, and also credit rating agencies. The Basel II IRB approach allows banks to model asset-specific risks using their own assumptions and modeling. These modeled risks are then used to calculate the risk weights that determine required levels of capital. Private ratings agency forecasts of default probabilities and loss given default are often key inputs into these models. During the financial crisis it became clear that bank internal risk models incorporated highly problematic assumptions, and in any case may not be well suited to forecasting the effects of systemic crises.5 It also became clear that ratings agencies faced deep conflicts of interest that contributed to profoundly flawed estimates of credit risk.6 Given this experience, regulators should avoid delegation of vital and complex regulatory responsibilities to private actors who face strong conflicts of interest due to profit motives. Given the opacity of financial institution internal risk modeling and the difficulty of providing proper oversight of such models, it may be necessary to seriously reexamine the dependence on internal modeling in regulating capital standards.7

While it is not a comprehensive solution to these issues, this rule should assist regulators in addressing both of them. The rule implements the intention of the Dodd-Frank act to set a clear, consistent, ongoing floor for minimum capital and leverage limits. This floor will not vary over the business cycle and therefore is not inherently pro-cyclical in ways that contribute to economic instability. It also does not depend on internal modeling decisions by profit-driven regulated entities which face significant conflicts between the interests of their shareholders and the public interest in systemic stability. Going forward, it is vital to maintain these principles and to effectively implement the floor called for in the Dodd-Frank act.

Some have criticized this approach as unduly constraining the regulatory flexibility necessary to implement Basel III and to address new challenges in financial regulation. This criticism is misguided. This rule leaves regulators substantial flexibility to amend capital rules over time, so long as such amendments do not result in any reduction in capital or leverage requirements compared to either the generally applicable rules for depository institutions, or the leverage or capital requirements in effect at the time of passage of the Dodd-Frank Act.

Beyond the general issue of the economic impact and justification for the permanent leverage and capital floor created by this rule, which AFR strongly favors, several other relevant questions are asked by the authors of the Proposed Rule.

Question 1: How should the proposed rule be applied to foreign banks in evaluating capital equivalency in the context of applications to establish branches or make bank or nonbank acquisitions in the United States, and in evaluating capital comparability in the context of foreign bank FHC declarations?

Foreign banks operating in the United States should be treated consistently with U.S. banks. This rule should therefore be applied to the U.S. operations of foreign banks in a manner that is as consistent as possible with the treatment of U.S. banks.

Question 4: The agencies request comment on the most appropriate method of conducting the aforementioned analysis. What are potential quantitative methods for comparing future capital requirements to ensure that any new capital framework is not quantitatively lower

than the requirements in effect as of the date of the enactment of the Act?

While AFR does not seek to comment in detail on this question at this time, we would call for an approach that ensures that future requirements hold all banks to the capital and leverage standards in effect for insured depository institutions at the time of passage of Dodd-Frank Act. Importantly, this requirement should be effective across all possible sets of exposures. An “on average” metric that permits capital or leverage standards to decline for some types of exposures while increasing them for others should be avoided and would clearly not be in accord with the intention of the Dodd-Frank Act.

The various Quantitative Impact Studies performed for Basel II offered a variety of methods of determining the impact on regulatory capital of implementing new capital rules across a wide variety of types of assets. These approaches may have to be expanded to incorporate the full range of possible types of exposures.

Assets not explicitly included in a lower risk weight category are assigned to the 100 percent risk weight category. Going forward, there may be situations where exposures of a depository institution holding company or a nonbank financial company supervised by the Board not only do not wholly fit within the terms of a risk weight category, but also impose risks that are not commensurate with the risk weight.

The proposed rule also points out that assets which have not been explicitly classified are currently given a 100 percent risk weight. AFR believes that in cases where asset characteristics have not yet been analyzed by regulators, the asset should be fully risk weighting (at 100 percent). If regulators feel such a weight is inappropriate then the characteristics should be analyzed and the asset class assigned an appropriate risk weight through the regulatory process.

Finally, as a general comment, we believe that capital adequacy rules are just one of many tools that need to be at the disposal of regulators to ensure a sound and solvent banking system. We would like to emphasize that ongoing capital regulation, liquidity requirements and consolidated supervision are all jointly of critical importance in preventing systemic threats from bank and nonbank companies.

Thank you again for this opportunity to comment on this NPR. If you have the further questions, please contact David Arkush, Director of Public Citizen’s Congress Watch at (202) 454-5130 or Heather McGhee, Director of the Washington Office of Demos at (202) 559-1543 ext. 105, Co-chairs of the AFR Systemic Risk and Resolution Authority Taskforce.


Americans for Financial Reform