As a new administration and a new Congress prepare to tackle a host of difficult financial regulatory issues, we have assembled a series of informational briefing materials to serve as background for that process. We have not included proposals for reform but rather have focused on providing a robust and factual assessment of the current state of the banking industry and the regulations that increasingly shape it.
This is an abridged version of our briefing materials found in the report “The State of American Banking,” which is available on our website. Most of the materials in that document are devoted to a rigorous analysis of the current state of capital and liquidity regulation, and efforts that have effectively ended concerns that large banks will require taxpayer assistance in a future crisis. Because of space constraints, this article provides only an overview of those analyses. To start, the article identifies a set of popular misconceptions – myths – that have served as a powerful distraction as policymakers have considered regulatory policy over the past few years.
Banking is, at its heart, liquidity transformation. Banks fund themselves with liquid deposits and invest in illiquid loans to businesses and households.
I. 7 Myths of Financial Services Regulation
MYTH NUMBER 1: Large banks lend to large businesses, and small banks lend to small businesses; therefore, the most effective way to prompt small-business growth is to provide regulatory relief to small banks.
In reality, large banks make a substantial share of loans made to small businesses – anywhere from 39% to 82%. Based on data collected and reported by the federal banking agencies, large U.S. banks originated 86% and 54% of small-business loans by number and by dollar volume, respectively, made by banks in 2015. Large banks held 39% of the small-business loans outstanding at the end of the second quarter of 2016.
MYTH NUMBER 2: The largest banks benefit from a “too big to fail” subsidy for their debt that gives them an unfair competitive advantage over other banks.
In reality, investors and markets appear convinced that equity and long-term debt holders are fully at risk in the event of failure, and that government assistance will not be required, or available, to resolve a large banking organization. Put another way, they appear convinced that large banks are no longer too big to fail. The spreads that debt markets charge large banks have risen dramatically from pre-crisis levels. In a 2014 study, the Government Accountability Office found that any premium in the interest rates (that is, lower rates) that banks pay to borrow in the bond market had been significantly reduced, eliminated, or even reversed.
Similarly, the ratings agencies now rate debt in accordance with the market reality reported by the GAO. The three large credit rating agencies have eliminated the “uplift” in ratings of bank holding companies because banks and credit agencies believe that the FDIC’s resolution process makes significant progress in eliminating expectations of government support.
MYTH NUMBER 3: There are limits to efficiencies of scale and scope in banking, and therefore the existence of very large banks must be the product of a subsidy or some other unnatural force.
There is a very large body of academic literature that finds larger banks can provide products and services at lower cost than smaller banks and this effect is stronger for the largest banks. One estimate that takes into account only operating costs suggests that limiting bank size to be no larger than 2% of GDP would increase noninterest expense up to 7%, or $22 billion per year for the banks subject to the size cap. In addition, technological advantages such as diversification and the dissemination of information costs also do not increase proportionally with bank size, which increases further the cost of breaking up big banks.
MYTH NUMBER 4: The leverage ratio is a sensible way to measure a bank’s capital adequacy.
A leverage ratio measures the capital adequacy of a bank by dividing its capital by its total assets. Although the leverage ratio is seen as an alternative to risk-based measures of capital, the leverage ratio is in fact a risk-based measure of capital, just a bad one because it assumes that the risk of each type of asset is the same. Our recent research also debunks another myth: that the leverage ratio was an accurate predictor during the recent financial crisis. Risk-based capital requirements are a better predictor of bank failure moving forward.
MYTH NUMBER 5: Banking is a highly concentrated industry.
Evidence suggests that the banking industry is unconcentrated and is one of the least concentrated major U.S. industries. Is concentration has changed little since the financial crisis. As shown in Figure 2, the degree of market concentration in the U.S. banking sector was little changed in the post-crisis period according to the Herfindahl-Hirschman index, the standard antitrust measure used by the Department of Justice across all industries.
MYTH NUMBER 6: Large banks have gotten larger.
After adjusting for inflation or as a share of the economy, the combined assets of the largest banks have declined since the passage of post-crisis banking reform. The U.S. banking agencies identify eight U.S. banking organizations as “global systemically important banks” or “GSIBs” – Bank of America, BNY Mellon, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street, and Wells Fargo. In second quarter of 2010, just prior to the passage of the Dodd-Frank Act, the combined assets of those banks equaled $9.64 trillion. In the second quarter of 2016, the combined assets equaled $10.72 trillion. But, after adjusting for inflation (using the Consumer Price Index except for food and energy), combined assets of the banks in 2016 equaled $9.58 trillion, slightly lower than in 2010. Moreover, the economy has also increased in size over that interval. In 2010, the combined assets equaled 66% of nominal GDP; in 2016 they equaled 58%, a substantial decline.
MYTH NUMBER 7: Large banks are “too big to jail.”
The reality is that corporations of all types are rarely prosecuted criminally, and for good reason. For banks, collateral consequences can be significant, including potential loss of their charter (effectively putting them out of business) and potential loss of their asset management subsidiary (even when the conviction has nothing to do with that business). Those decrying banks as “too big to jail” are effectively demanding that the Department of Justice abandon the principles it applies in dealing with every other industry, forgo the careful consideration of the wider consequences of their actions and the ends of justice.
II. Financial Resilience: Assessing the Strength of the U.S. Banking System
In the aftermath of the global financial crisis, banks in the United States and abroad have substantially increased their resiliency – that is, their ability to absorb losses or market shocks – by strengthening their capital levels, improving the liquidity of their balance sheets, and reducing their interconnectivity with other financial institutions. These improvements in the resiliency of the banking system have been reinforced by a series of key capital and liquidity rules that have been enacted in the United States, including the Basel III capital and liquidity frameworks as adopted in more stringent form in the United States, and U.S.-only annual stress tests.
Sizable Improvements in the Capital and Liquidity Positions of Large Banks
The aggregate common equity tier 1 (CET1) ratio across all of The Clearing House’s 24 owner banks rose from 4.6% at the end of 2008 to 12.1% by the second quarter of 2016 (Figure 3).4 Moreover, the level of capital that now exists in the U.S. banking system is not merely a transitory trend; a series of regulatory requirements either has driven these changes or prevents their reversal. (Note: Common equity tier 1 equals common shares, common stock related surplus, and retained earnings adjusted by the relevant regulatory adjustments set out in paragraphs 66-90 of the Basel III rules text (e.g., goodwill and intangibles)).
In addition, capital regulation now emphasizes stress testing to measure banks’ capital adequacy. During these stress test scenarios, large banks must not only remain solvent but rather well capitalized – meeting a series of post-stress capital requirements, including holding 4.5% common equity against risk-weighted assets. In the most recent stress tests, conducted in 2016, the aggregate projected common equity tier 1 ratio for the 33 bank holding companies that participated fell from about 12% at the end of 2015, to a post-stress minimum level of 8% under the severely adverse scenario in the Dodd-Frank Act Stress Tests, but remained well above the minimum requirement of 4.5%. (Note: The quantitative assessment of a bank’s capital plan also requires a tier 1 risk-based capital ratio above 6%, a total risk-based capital ratio above 8% and a tier 1 leverage ratio above 4%.)
The balance sheets of large banks are now also dramatically more liquid, and thus substantially less likely to fall victim to a run by depositors or other short-term creditors. As shown in Figure 4, large banks now hold about 24% of their balance sheet in the form of high-quality liquid assets (HQLA), nearly five times higher than the share they held pre-crisis. (Note: HQLA include cash reserves held at Federal Reserve Banks, U.S. Treasury securities, government-sponsored agency securities, and a small set of other assets that can be sold for value even under extreme stress.)
A Quantitative Assessment of the Resiliency of the U.S. Banking Sector
The Clearing House has recently developed an index that is a quantitative assessment of the resiliency of the U.S. banking sector. The Clearing House Bank Conditions Index (TCHBCI) is constructed using a wide range of indicators that are commonly used to characterize the condition of the banking sector. The TCHBCI synthesizes data on 23 banking indicators, grouped into six categories: capital, liquidity, risk appetite, asset quality, interconnectedness, and profitability. The index helps to assess the impact of changes in the regulatory landscape on overall bank condition using a large variety of banking indicators.
As shown in Figure 5, during the 2007–2009 global financial crisis, the categories of the TCHBCI that started showing the most vulnerability were liquidity and capital. During the financial crisis, the increase in the vulnerability of the banking sector became widespread across all categories of the overall index. In the aftermath of the crisis, TCHBCI shows that the capital and liquidity positions of U.S. banks have improved significantly. Risk-taking has remained at relatively subdued levels and has increased only slightly over the past few years, mostly driven by an increase in risk weights as a result of changes in regulation. Meanwhile, the degree of connectivity among financial institutions has decreased at a moderate pace in the post-financial crisis period.
A complete discussion of how the TCHBCI is assembled and how to interpret the levels of the index is available online.
III. The New Resolution Paradigm: Ending Taxpayer BailOuts for Large Banks
One of the most immediate and obvious lessons from the recent financial crisis was the need for a bankruptcy or insolvency regime that could allow large financial institution to fail in an orderly way. Policymakers committed to ensure that no institution is too big to fail by creating a framework to guarantee that all institutions are safe to fail.
Ensuring Large Banks Can Fail Safely Without Taxpayer Support
The new resolution regime that emerged to eliminate the too-big-to-fail problem consists of two key components: a legal framework and an operational framework.
Legal Framework. The Dodd-Frank legal framework is made up of two key parts: (1) bankruptcy as a first option and (2) FDIC resolution in the event that bankruptcy is not practical.
Every large banking institution must prepare and maintain a prepackaged bankruptcy plan (known as a living will) that credibly demonstrates how the institution would be resolved under the U.S. Bankruptcy Code in an orderly way should it experience financial distress or failure. It also includes devising strategies for ensuring the bankruptcy can be conducted in a way that minimizes disruption to customers and the broader financial system.
If for some reason bankruptcy does not prove a viable option, Title II of Dodd-Frank authorizes the FDIC to resolve a bank’s parent company in much the same way it has traditionally resolved banks – large and small. While the legal structure for the resolution – the single-point-of-entry, or SPOE, strategy – will in most cases be much the same, Title II allows the FDIC to provide a liquidity line to support the resolution, akin to a discount window loan, as it is on good collateral. Title II contains provisions designed to ensure that taxpayers aren’t on the hook for bailing out troubled financial institutions.
Operational Framework. In the six years since the enactment of Dodd-Frank, the FDIC and the Federal Reserve have led an effort to operationalize an effective and reliable resolution framework for globally active banking organizations largely through the creation and development of the SPOE resolution strategy.
Clear Evidence of Success
As discussed above, investors and markets appear convinced that equity and long-term debt holders are fully at risk in the event of failure, and that government assistance will not be required, or available, to resolve a large banking organization.
IV. Capital and Liquidity Regulation
Following the most recent financial crisis, both financial institutions and regulators have focused on measures intended to improve and maintain both levels and quality of capital and liquidity to improve banks’ resiliency and solvency. Capital insulates a bank against unexpected losses; liquidity prevents a run on a bank if its short-term creditors experience a crisis of confidence.
Capital Rules Enacted Since The Crisis
International Standard Setting. In December 2011, the Basel Committee on Banking Supervision (BCBS) released the Basel III framework (Basel III Capital Rules), which sought to solve key weaknesses in the financial system that caused or contributed to the global financial crisis, including: enhancing the quality of bank capital and increasing the overall level of capital; constraining leverage and excessive risk concentration; and addressing liquidity risk. Under Basel III Capital Rules, capital is regulated both through comparing capital to (i) risk-weighted assets (that is, the risk-weighted capital ratio) and (ii) total assets (leverage ratio). The risk-weighted capital ratio assigns risk weights to assets, or classes of assets, based on the perceived risk that the asset may lose value. The higher the assigned risk weight of an asset, the more capital a bank is required to hold against such asset. As discussed earlier, the leverage ratio does not take into account the riskiness of any particular asset and therefore requires the same amount of capital to be held against all types of assets.
U.S. Implementation of Basel III Capital Rules. In 2013, the U.S. bank regulatory agencies8 (U.S. Agencies) finalized three related rules implementing the Basel III regulatory capital reforms and other changes required by the Dodd-Frank Wall Street Reform and Consumer Protection Act (aka, the Dodd-Frank Act). (Note: For the purpose of this paper, the U.S. bank regulatory agencies are the Board of Governors of the Federal Reserve (Federal Reserve), the Office of the Comptroller of the Currency (OCC) and the Federal Deposit Insurance Corporation (FDIC).)
These rules outline two different approaches for risk-weighted capital ratios: the standardized approach and the advanced approaches. Under the standardized approach, regulators assign each asset a risk weight that determines how much capital is required be held against such asset. Under advanced approaches, some larger banks are also required to use an internal ratings-based approach to calculate the amount of capital that must be held against each asset. Notably, the Collins Amendment to the Dodd-Frank Act requires these advanced-approaches banks to hold at least the amount of capital required under the standardized approach, such that there is no capital benefit permitted from using bank internal models.
Quality and Quantity of Capital. The U.S. implementation of the capital rules associated with Basel III (that is, Basel III Capital Rules) has greatly increased both the quantity and the quality of capital held by banks. With respect to quality, the Basel III Capital Rules largely rely on a form of capital known as Common Equity Tier 1 (CET1), which is considered the highest quality form of capital, consisting largely of issued stock and retained earnings. Although CET1 capital was included in the pre-crisis measure of Tier 1 Capital, the CET1 requirement is more restrictive than the pre-crisis Tier 1 Capital requirement. With respect to the overall quantity of capital, banks are required to maintain a higher amount of capital post-crisis than they were pre-crisis, as demonstrated by Figure 6. (Note: Common Equity Tier 1: generally considered the highest quality form of capital; Additional Tier 1: more expansive, includes some types of preferred stock; Tier 2: includes other types of preferred stock and some subordinated debt and accounting reserves. The items with an asterisk serve as de facto minimums, as falling below these minimums would subject banks to restrictions on capital distributions and executive bonus payments.)
CCAR/DFAST. Following the height of the financial crisis, the Federal Reserve implemented capital stress tests that have evolved into what is currently known as the Comprehensive Capital Analysis and Review (CCAR). The annual CCAR exercise has become a key component of how the Federal Reserve ensures that banks are sufficiently resilient by requiring banks to have enough capital to meet minimum capital requirements at the end of the nine-quarter severely adverse scenario. In addition to CCAR’s quantitative requirements, banks are also assessed on a series of qualitative factors, including a firm’s risk management, internal controls, and governance supporting the capital planning process.
In addition to CCAR, banks participate in a capital stress test exercise pursuant to the Dodd-Frank Act known as DFAST. Although similar to CCAR, DFAST is different in that both the Federal Reserve and the banks run the balance sheet projections through their own models.
GSIB Surcharge. In 2013, the BCBS issued a rule imposing a capital surcharge for global systemically important banks (GSIBs). The GSIB surcharge is intended to reduce the probability of failure of a GSIB relative to that of a non-GSIB to offset the relatively greater systemic costs of a GSIB’s failure.
Leverage Ratio. Unlike other major international jurisdictions, commercial banks in the United States have been required to satisfy a leverage ratio requirement for on-balance sheet assets since 1981. Internationally, Basel III included a 3% supplementary leverage ratio for all internationally active banks, which includes both on and off-balance sheet assets. In 2014, the U.S. Agencies also finalized a rule requiring U.S. GSIBs to maintain a minimum enhanced supplementary leverage requirement (eSLR) of 5% in their holding company and 6% in their depository institution subsidiaries.
Liquidity Rules Enacted Since the Crisis
The post-crisis regulatory response to liquidity issues was primarily addressed through the Basel III liquidity framework, which established international quantitative liquidity standards for the first time. The Basel III liquidity framework established two new standards, the liquidity coverage ratio (LCR) and the net stable funding ratio (NSFR), which are currently (or soon will be) used by supervisors to regulate bank funding and liquidity. The LCR was finalized in 2014 in the U.S. and the NSFR is currently proposed.
LCR. The LCR was designed to ensure that a bank has sufficient liquidity to sustain a severe 30-day period of idiosyncratic and market-wide stress. The U.S. LCR requires banks to maintain a sufficient stock of HQLA to cover expected net cash outflows, which is calculated pursuant to certain regulatory assumptions, over a 30-day period.
Liquidity Stress Testing/CLAR. In 2014, U.S. agencies finalized liquidity standards pursuant to Section 165 of the Dodd-Frank Act that are designed to complement the quantitative Basel III standards. In 2012, the Federal Reserve began using such reviews, known as Comprehensive Liquidity Analysis and Reviews (CLAR), for the largest U.S. financial institutions. However, CLAR has grown to include all institutions in the Large Institution Supervision Coordinating Committee portfolio.
Further Capital & Liquidity Rules That Are Pending or Proposed
Notwithstanding the substantial changes already enacted, there are yet further reforms pending or proposed with respect to capital and liquidity rules. Most notably, for capital these include (i) changes to the annual CCAR exercise and related post-stress capital requirements, (ii) possible changes to the leverage ratio framework, and (iii) the Basel IV capital framework. For liquidity these include (i) finalization of the NSFR and (ii) changes to the LCR’s classification of municipal securities. Further detail on each of these items is discussed in the complete report.
V. Emerging Challenges in Bank Intermediation
The post-crisis reform of bank regulation and supervision has made large banks safer and more resilient, but sound government regulation requires that decisions be made with an awareness of the costs as well as the benefits. An assessment of net benefits is especially important as consideration moves beyond the regulations with the clearest positive net benefit, which were the first to be adopted.
In the complete report, we conduct an in-depth review of ways that recent regulations have curtailed the ability of banks to engage in or support the core function of the financial system – matching those with funds they wish to save and invest with businesses, households, and governments that want to borrow to support spending on capital, durable goods, and housing. We focus in particular on three areas:
How the design of the stress tests encourage banks to reduce lending to middle-class households and small businesses;
How a proposed liquidity regulation as well as the living wills make it more costly for banks to take in deposits and extend loans; and
How several regulations have led banks to cut back sharply their support for intermediation between investors and borrowers in capital markets
Stress Tests and Lending to Middle Class households and Small Businesses
Each year, Federal Reserve supervisors prepare a forecast of each large banks’ capital levels under the assumption that the economy enters an extremely severe recession or, if already in a recession, that the recession gets significantly worse. Naturally, the loans that perform the worst under such assumptions are ones to households more at risk of losing their jobs if a recession occurs and with only modest savings and loans to newly formed small businesses, so banks have a strong incentive to substitute away from such loans to do better on the stress test. The consequences of those incentives can be seen in the continued tight supply of credit to households, except the wealthy, while small-business formation and employment has remained sluggish during the recovery.
Liquidity Regulations, Living Wills, and Bank Lending
Banking is, at its heart, liquidity transformation. Banks fund themselves with liquid deposits and invest in illiquid loans to businesses and households. Liquidity transformation can be potentially unstable, however, because each individual depositor or overnight creditor has an incentive to run if there is a whiff of trouble, but the bank can’t liquidate its illiquid assets to meet the run. One way to eliminate this inherent risk is, of course, to require banks to make no loans and hold only completely safe and liquid assets such as Treasury bills. Another is to require banks to stop offering savings or checking accounts and fund themselves only with long-term debt. For a variety of reasons, however, modern economies have consistently opted for a banking system in which lending and deposit-taking are combined.
Many financial institutions experienced severe liquidity problems during the financial crisis, and the bank regulatory agencies tightened liquidity requirements in response. As a result of one proposed new liquidity requirement, the NSFR, in the future banks may need to reduce their provision of credit to nonfinancial businesses – including small businesses – and households and reduce their support of capital market intermediation in order to continue to comply with the NSFR.
Additionally, recent decisions by the Federal Reserve and Federal Deposit Insurance Corp. on the living wills of several U.S. banks, while phrased as bank-specific decisions on the credibility of a firm’s resolution plan, effectively make important policy decisions about the ability of U.S. banks to engage in liquidity transformation. The living-will guidance would appear to make it even more expensive for banks to engage in liquidity transformation. The potentially profound impact of these new policies on economic and job growth may be one reason why the GAO suggested that the agencies should be more transparent about the criteria they are applying when determining if the living wills are credible.
Regulations and Bank Support for Capital Markets
As described above, tighter bank regulations inevitably reduce the supply of bank credit and channel credit toward or away from certain sectors. However, in the United States, much of lending to the private nonfinancial sector and most of the borrowing by the government sector occurs outside the banking system in capital or money markets. Indeed, banks provide only about one-third of credit in the United States. The commercial bank and broker-dealer subsidiaries of large bank holding companies facilitate financial market intermediation both by making markets in the securities traded in those markets as well as providing the funding to financial institutions necessary for the liquidity and efficiency of those markets.
Several of the regulations described in this report make it more costly for banks and bank holding companies to engage in capital market activities, such as the GSIB surcharge, the leverage ratio, and the Volcker Rule. And several regulations on the horizon will make such activities even more costly. For example, the recent proposal of Daniel Tarullo, Governor of the Federal Reserve Board, to add the GSIB surcharge to the stress tests will make banks even more eager to reduce their capital markets footprint and thereby lower their surcharge.
In the complete report, we present evidence on weak bond issuance by smaller firms and changes in the efficiency and liquidity of financial markets based on analysis of data from repo markets. These analyses suggest consequences of these new regulations including a decrease in issuance of corporate bonds by small and midsized nonfinancial firms, the reduced ability of financial institutions to finance large positions, and higher costs to taxpayers of the national debt.