Introduction
In July, the Federal Reserve and other banking agencies issued a proposal representing the most significant change to large bank capital requirements since the financial crisis. The proposal estimates that Forum members would see their required capital increase by roughly 20 percent, which is a larger increase than would be experienced by other banks subject to the proposal. This result is a real head-scratcher because Forum members have already tripled their capital since the financial crisis, are subject to prudential standards that are more stringent than those applied to other banks, and have clearly demonstrated their capital strength during the unprecedented turmoil of the past few years.
Recently, economists at the Federal Reserve Bank of New York issued a research post that systematically evaluates the resiliency of the entire U.S. banking sector. Overall, they find that “systemic vulnerability still remains below the high levels preceding the 2008 crisis, especially because the largest banks tend to be less exposed to capital shortfalls, fire sales, liquidity mismatches, and run risk relative to smaller institutions.” This research finding speaks volumes about the illogic of the treatment of Forum members in the recent capital proposal. Specifically, how can it be appropriate to increase capital the most for precisely those banks that are contributing the most to the banking sector’s resiliency through their smaller exposure to capital shortfalls?
Data Trumps Talking Points
The research from economists at the Federal Reserve Bank of New York is a regular follow up to an annual post that assesses the resiliency of the U.S. banking sector across four key dimensions: capital strength, fire sale vulnerability, liquidity, and funding stability. This year’s update is broadly similar to the findings that have been reported over the past several years. Specifically, since the financial crisis of 2008, capital strength has improved, fire-sale risks have declined, liquidity profiles have improved and sources of stable funding have deepened, the research shows. Against the backdrop of these systematic, data-based research findings, it is difficult to understand the zeal among regulators for ever higher levels of required capital. More still, it is even harder to understand why the incidence of increased required capital should fall heaviest on those banks that are the most well capitalized and resilient: Forum members.
In response to the 2023 bank failures, the analysis conducted this year made some changes to the analysis methodology to reflect all unrealized losses on securities. As acknowledged by the authors, this approach creates a divergence from “regulatory standards where unrealized gains and losses on available-for-sale securities are not included in regulatory capital except for the very largest banks,” all of which are Forum members. Once again, the analysis presented in this post underscores the undeniable fact that Forum members are already subject to the most stringent regulatory standards and serve as a clear source of strength and resiliency to the banking sector and entire U.S. economy.
The research post does find that making these changes to the methodology suggests a short-lived and modest increase in banking sector vulnerability relative to the period immediately preceding the 2023 turmoil, but the overall trend in vulnerability is clear: banking sector vulnerability is low and has been declining steadily since 2008 in large measure due to the strength and resilience of our nation’s largest banks.
This final point is important because the 2023 banking turmoil has been routinely cited as a motivation for the capital proposal. Whatever one’s views on the events of 2023 and its nexus with bank capital, one thing is abundantly clear: the events of 2023 were not caused by Forum members, were not related to their capital position, and those events say nothing whatsoever about the adequacy of the prudential framework that applies to Forum members.
Conclusion
The bottom line of the analysis presented by the Federal Reserve Bank of New York’s research is that overall systemic vulnerability is low and that the low level is largely driven by the strong and resilient nature of Forum members. This finding exposes a clear and stunning logical flaw in the recent capital proposal. The U.S. banking sector is remarkably resilient because of the significant strength and resiliency of Forum members. Any capital proposal that seeks to levy the largest capital increase on those banks that contribute the most to the sector’s overall safety and soundness is deeply and irrevocably flawed.