Blog: Fed Should Ignore Megabank Lobby and Strengthen Capital Rules

By Carter Dougherty and Renita Marcellin

As the Federal Reserve prepares new capital rules for American banks, Wall Street is rolling out its misdirection and bad arguments – as it has for much of the past decade – about why they should not be required to steel themselves against a crisis or downturn. And once again, regulators and Congress must be prepared to ignore their histrionics and strengthen capital requirements.

The megabank lobby is repeating the same tired arguments about alleged harms to economic growth while obscuring how banks profit from weaker capital rules, which allow them to make risky bets subsidized by their customer’s deposits. The answer of the Federal Reserve must be to strengthen capital requirements and compensate for any changes in the direction of weaker rules with offsetting measures.

For some perspective, the 2008 crisis had barely ebbed before Wall Street started pushing back against higher capital requirements, claiming – falsely – that they would harm economic growth by restricting lending. After the first round of reform, by 2014, evidence piled up refuting the bank lobby’s claims. In the words of one scholar supporting higher capital requirements, “the optimists were not optimistic enough.”

Basel Endgame

Federal regulators are now working on the implementation of the “Basel endgame” – the coda to the post-crisis global framework for bank capital under the Basel Committee, the international body named after the Swiss city where it convenes.

In addition, Fed Vice Chair for Supervision Michael Barr raised the bar by announcing a “holistic” review of capital rules since the 2008 crisis, a vital step since his Trump-appointed predecessor watered down important provisions. And since big banks are apparently hoping Fed chair Jerome Powell will restrain Barr, it’s worth remembering that Powell, as part of his bid to get a second term, explicitly promised to defer to the vice chair.

We are again seeing the bank lobby peddling an outright falsehood about what bank capital actually is. It is simply the net worth of a bank, also known as equity or equity capital. Non-financial companies can return this money back to shareholders as dividends, use it for stock buybacks, or reinvest it into the company. But because the business of banking comes with unique risks not associated with other industries, regulators require banks to hold onto some of this equity for an extra cushion to ride out downturns. Banks raise it by selling shares of stock or retaining earnings.

Bank capital is not, as lobbyists claim, money that is locked away and thus cannot be used for lending, nor do higher capital levels stop banks from supporting economic activity. Regulators calibrate what they call capital charges against the varied risks associated with different activities, so that lending to hedge funds, for example, would require a stronger capital buffer than a small-business loan. But capital requirements are currently far below the threshold that would theoretically hamper economic activity.

Bank Lobby Misdirection

The Bank Policy Institute, a big-bank lobby group, recently used a literature review done by the Basel Committee on the effects of bank capital requirements to claim that a single percentage point increase in capital requirements can reduce GDP by up to 16 basis points. However, the same study calculated the optimal leverage ratio for banks is 19 percent, much higher than the current minimum requirement of 3 percent.

The Basel review cited other studies that showed increased capital requirements led to a 18 basis point reduction in the cost of a financial crisis. In other words, tougher capital rules help prevent a downturn from becoming a banking crisis.

The European Central Bank also recently rebuffed criticism of higher capital requirements by pointing out the downside to weaker rules. “It is also questionable that lower capital requirements would lead to higher lending: what is proven is that low levels of capital lead banks to abruptly reduce lending in a crisis, thus deepening the adverse impact on the economy,” the ECB said.

Put another way: the consequences of stronger capital rules have been benign to positive. The consequences of weak rules in the past were catastrophic.

Banker Pay at Stake

Jamie Dimon, the CEO of JPMorgan Chase, has repeatedly complained about the “gold-plating” of international capital rules by U.S. regulators, a reference to the supplementary leverage ratio. The SLR, as it’s known, imposes an extra requirement on the largest banks precisely because instability or collapse at these institutions would have grave, worldwide consequences – as the failure of Lehman Brothers demonstrated in 2008.

But the part Dimon leaves out is that higher capital requirements do not bode well for his pay. Bank CEOs and executives, usually large shareholders of bank stock, are forced to pay less in dividends or limit stock buybacks—which raises the value of their stock—when capital requirements are higher. Safer banks simply aren’t as lucrative for executive pay.

Banks have long pointed to the misguided actions of others to justify deregulation. On the other side of the Atlantic, home to many of the world’s other megabanks, a mixture of ferocious industry lobbying and opportunistic politicians is leading the European Union to pursue a less-than-ideal implementation of its Basel commitments, according to Brussels-based Finance Watch, a leading European financial reform advocate.

If the EU continues in that direction, we should expect American mega-banks to point to their European competitors as a reason why the Fed needs to deviate from the internationally agreed rules. The Fed should resist that demand.

Regulate Shadow Banking

Additionally, the industry is now pointing to the under-regulated shadow banking system to stoke fears among lawmakers about who will take over if banks are unable to lend as much because of higher capital requirements. The answer to this conundrum is for regulators to create better rules of the road non-bank financials, not take their hands off the wheel for everyone. The SEC and the CFPB are leading the charge in taming the shadow-banking system. If the big banks acknowledge the threats posed by the growing shadow-banking system, they too should be supporting the work of these agencies – and more.

Lastly, the Wall Street lobby will also insist that the unprecedented experience of the COVID-19 pandemic demonstrates the fitness of banks, an argument that’s silly on its face. Banks didn’t face trouble because Congress acted to stabilize the economy with massive relief and the Federal Reserve offered no-strings-attached liquidity and exempted banks from compliance with key rules. It was not the 2008 rescue. But it was a back-door bailout of Wall Street nonetheless.

There is one area in which the Federal Reserve might ease capital rules when it comes to U.S. Treasury securities, though this is not a step AFR advocates. Since the smooth functioning of this market is essential for financial stability, the Fed could ease the capital charges against these assets in order to facilitate that market. However, there is also a strong case that this change would not solve underlying problems in the Treasury market. In any case, the Fed should use other tools, like raising overall leverage requirements to offset any change. (The Fed can also adjust the countercyclical capital buffer, now at zero, to affect capital levels.)

Ultimately, the Fed should use all the levers at its disposal to create a robust capital framework for banks and undo the damage inflicted by Trump-appointed regulators. Although 2008 may seem like a distant memory, the effects of the financial crisis are etched deeply in the lives of many families and communities who may never fully recover from its effects. And the world almost got a look at what could have happened to banks again during the pandemic. U.S. regulators should not cave into industry pressure – now or ever.