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Sean Campbell

Chief Economist, Head of Policy Research

<h3>Introduction</h3>The size and depth of U.S. capital markets is the envy of the world and facilitates a significant amount of corporate investment that helps grow our economy.&nbsp; Companies raise funds from capital markets by issuing equity and debt securities to a variety of investors, including pension funds, mutual funds, and households.&nbsp; This critical activity is facilitated largely by large bank intermediaries that “make markets” in these securities.&nbsp; In the U.S., Financial Services Forum members account for roughly three-fourths of this market-making activity.&nbsp; U.S. regulators recently <a href="https://www.federalreserve.gov/newsevents/pressreleases/bcreg20230727a.htm">proposed</a> a significant increase in bank capital requirements, known as Basel III Finalization, that would substantially increase the cost of market making.&nbsp; The proposal would increase the cost of corporate investment and for investors to buy and sell these securities in the open market.&nbsp; In this post, we will discuss the role of capital in market making, recent trends in market-making activity, the potential impact of the proposed requirements on the provision of market-making services by banks as well as their likely impact on overall financial stability.&nbsp;<h3>Large Banks, Securities Underwriting, and Market Making</h3>A wide range of U.S. companies raise investment funds from the public by issuing debt and equity securities.&nbsp; These funds are then used for a variety of investment purposes such as new factories, research and development, or expansion into new markets.&nbsp; All of these activities support our economy.&nbsp; Companies typically raise investment funds by partnering with a large bank to execute the sale of the securities.&nbsp; A large bank will buy a fixed amount of securities from the company and then market the securities to investors such as pension funds, mutual funds, and households who want to purchase these securities for saving and investment purposes.Once the securities have been sold to investors, large bank intermediaries play a further, critical role.&nbsp; At some point, an initial investor, such as a pension fund, will need to sell the security it owns to raise cash.&nbsp; Similarly, another investor may have a need to purchase a security, perhaps because it has recently received cash that it needs to invest.&nbsp; Large bank intermediaries operate a constant market for these corporate securities to ensure that both buyers and sellers of securities have a ready market in which they can transact easily and at reasonable cost.&nbsp; Without banks acting as market makers, it would be very difficult and costly for buyers and sellers of corporate securities to adjust their holdings as their needs change.&nbsp; Accordingly, market-making activities by banks are critical to ensure well-functioning capital markets.In order to maintain a ready market, large bank market makers maintain an inventory of corporate securities.&nbsp; This inventory is actively used to make markets and ensure that market participants can readily transact at reasonable cost.&nbsp; To analogize, this is akin to the inventory at a car dealership.&nbsp; A car dealer without any inventory will be hard-pressed to facilitate any car sales or purchases!&nbsp; Similarly, bank market makers need to maintain sufficient securities inventory to facilitate security purchases and sales.&nbsp; A market in which buyers and sellers can transact easily and at reasonable cost is known as a “liquid” market and market makers effectively provide liquidity to the public by maintaining a sizeable inventory of securities.&nbsp;&nbsp;&nbsp; &nbsp;&nbsp;&nbsp;<h3>Bank Capital and Market Making</h3>As we all know from watching the stock market, security prices go up and security prices go down.&nbsp; Accordingly, banks that actively hold sizeable securities inventories need appropriate capital to ensure that they can withstand market fluctuations.&nbsp; At the same time, equity capital is costly.&nbsp; As a result, while maintaining more capital improves a bank’s safety, it also raises the cost of providing market-making services to investors.&nbsp; Significant increases in required capital for market-making activity would increase costs and lead to smaller inventories and less liquid markets.&nbsp; Indeed, the past decade provides a clear case study of how increased capital requirements lead to less liquid capital markets.<h3>Market Risk Capital Requirements and Market Liquidity: Recent Evidence</h3>Following the 2008 financial crisis, bank regulators substantially raised the amount of capital that is required of banks to engage in market-making activities.&nbsp; These increased capital requirements came in two forms.<ul><li>First, global bank regulators increased market-making capital requirements through what is commonly referred to as “Basel 2.5.”&nbsp; According to <a href="https://www.bis.org/bcbs/publ/d352_note.pdf">regulators</a>, Basel 2.5 increased market-making capital requirements by 40 percent.</li><li>Second, in the U.S., bank regulators introduced a new stress testing capital regime that applied an extremely conservative “market shock” to market-making inventories that further increased required capital for market-making activities.</li></ul>So, what has been the impact of these significant increases in capital requirements?&nbsp; The chart below addresses this question in two ways.&nbsp; First, the chart shows the proportion of all large bank assets devoted to market making assets such as stocks, bonds, commodities, and derivatives.&nbsp; Second, the chart also shows data for a narrower class of securities - corporate bonds held by market makers.&nbsp;The fraction of market-making assets held by banks (blue line) has declined from roughly 20 percent to about 15 percent since 2010.&nbsp; The second line in the chart shows the experience for the more narrow class of corporate bonds (orange line).&nbsp; As shown in the chart, market makers have substantially reduced their inventory of corporate bonds over the same period.&nbsp; As regulators markedly increased required capital, large banks have reduced their inventories to conserve capital.<figure class="image"><img src="https://fsforum.com/a/media/picture1.png"></figure>Source: Financial Accounts of the United States, Quarterly Trends for Consolidated U.S. Banking OrganizationsGiven the demonstrable decline in inventories, is there any evidence that capital markets have suffered as a result?&nbsp; Yes.&nbsp; A broad range of market <a href="https://www.ft.com/content/cbc47bbf-f158-4330-9e29-5b0b71935140">commentary</a> has noted a steady decline in the liquidity of capital markets over the past decade.&nbsp; In addition, reports from the official sector such as the International Monetary Fund (<a href="https://www.imf.org/External/Pubs/FT/GFSR/2015/02/pdf/c2_v2.pdf">IMF</a>) and the Committee on the Global Financial System (<a href="https://www.bis.org/publ/cgfs55.pdf">CGFS</a>) have discussed the issue of declining liquidity over the past decade, including the contribution arising from reduced inventories of market makers.&nbsp; The clear link between rising market-making capital requirements, declining inventories, and reduced market liquidity raises serious questions about a further, unnecessary increase in market-making capital requirements.<h3>Proposed Bank Capital Increase is Unnecessary and Would Further Worsen Market Liquidity</h3>The new requirements that are being proposed by U.S. regulators would significantly increase capital requirements for market-making activities.&nbsp; According to the proposal’s own <a href="https://www.federalreserve.gov/aboutthefed/boardmeetings/frn-basel-iii-20230727.pdf">analysis</a>, the amount of large bank capital required to make markets would increase by more than 75 percent.In light of such a significant increase in capital, it is important to ask what specific events or facts suggest such an increase is necessary?&nbsp; Previously we discussed Basel 2.5 and the advent of stress testing.&nbsp; Both developments followed the financial crisis.&nbsp; And while one may argue about the causes of the financial crisis or the role played by financial market activities, there was a clear economic event that precipitated these changes.There is no analogous event or fact pattern in the present situation.&nbsp; U.S. regulators are proposing a substantial increase in the required capital for market making yet there have not been any events to suggest that these activities are undercapitalized.&nbsp; Rather, the contrary is true.&nbsp; During the real-world stress test of the COVID pandemic, financial markets came under significant stress, but large banks performed extremely well while also engaging in record-breaking amounts of securities <a href="https://fsforum.com/news/forum-members-help-companies-access-market-finance-during-the-pandemic">underwriting</a> to support a wide range of companies that needed financing to deal with the challenges presented by the pandemic.An increase in required capital of this magnitude would only exacerbate recent trends that have challenged market liquidity.&nbsp; Ultimately, increased requirements would increase costs for companies seeking to make investments to grow the economy as well as savers looking for a liquid store of value for their hard-earned investment capital.&nbsp; At the same time, given the already significant increases in capital over the past decade, further increasing capital would have relatively small effects on the safety of market-making activities.<h3>Increased Market-Making Capital Requirements Would Drive Activity Outside the Banking System</h3>Finally, it is critical to consider the effect that raising capital would have on the overall composition of our financial system.&nbsp; Over the past decade or so, much capital market activity has migrated out of the highly regulated banking system and into less well-regulated non-banks.&nbsp; As a specific example, today roughly <a href="https://www.ecb.europa.eu/pub/economic-research/resbull/2020/html/ecb.rb201215~210477c6b0.en.html">50</a> percent of U.S. equity trading is handled by high-frequency trading (HFT) firms, which are outside the banking system.&nbsp; As bank capital requirements for market-making services increase, banks become less competitive in offering these services and non-banks may fill the void.&nbsp; A trend toward non-banks raises serious questions about financial stability as these non-banks typically are not subject to bank-style capital (or liquidity) requirements and may pose broader risks to financial stability – especially in times of market stress when market-making services are in such high demand.&nbsp; In this vein, <a href="https://www.fsb.org/2021/10/lessons-learnt-from-the-covid-19-pandemic-from-a-financial-stability-perspective-final-report/">analyses</a> of events surrounding the COVID pandemic have suggested that non-banks were more fragile and less resilient than highly regulated banks.&nbsp; As a result, the current proposal to increase market-making capital requirements is even more concerning because it may further alter the balance of banks and non-banks in the provision of capital market services.&nbsp;&nbsp;&nbsp; &nbsp;&nbsp;&nbsp;&nbsp; &nbsp;&nbsp;<h3>Conclusion</h3>U.S. capital markets are the envy of the world.&nbsp; Everyday companies use these markets to raise funding for needed investments that grow our economy.&nbsp; At the same time, savers use these markets to find a liquid and valuable store of value for their hard-earned savings.&nbsp; Over the past decade or so, bank capital requirements have increased tremendously, and market liquidity has broadly declined, which has raised costs for companies seeking investment capital and savers looking for a solid financial return on their capital.&nbsp; The Basel III Finalization proposal would dramatically increase required capital for market-making activities by an additional 75 percent for large banks.&nbsp; The proposed increase is not tied to any observable increase in financial risks or specific events that would, in any way, suggest that market-making capital is too low.&nbsp; Rather, available evidence clearly demonstrates that large bank market makers have been resilient during times of stress while their non-bank counterparts have been demonstrably less resilient.&nbsp; Imposing unnecessary costs on companies, savers, and investors would harm our capital markets and the economy.&nbsp; U.S. regulators should revisit their proposal and avoid these impacts before finalizing, otherwise we will see further strain on market liquidity and increased potential for financial instability.

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We advocate for sound policies that recognize the importance of ensuring that banks are able to support the economy, compete internationally, and remain strong. In particular, the Forum supports a review of the GSIB surcharge, a capital requirement that was agreed to internationally, but that U.S. regulators have implemented in a manner that places higher requirements on U.S. banks than that required of foreign competitors. 

The Forum has also weighed in on an international assessment of post-crisis reforms and the clear need to differentiate between jurisdictions and to acknowledge the progress made in the United States.


Capital and Financial Stability

Capital Insights: Proposed Market-Making Requirement a Threat to Liquidity, Economy, and Financial Stability 

<h3>Introduction</h3>Recently, the Federal Reserve, Federal Deposit Insurance Corporation, and the Office of the Comptroller of the Currency (US agencies) issued a <a href="https://www.federalreserve.gov/newsevents/pressreleases/bcreg20230727a.htm">proposal</a> to increase capital requirements for all banks with total assets greater than $100 billion.&nbsp; This proposal is directly based on a revised capital <a href="https://www.bis.org/bcbs/publ/d424.htm">framework</a> that was agreed to by a group of global bank regulators, known as the Basel Committee on Banking Supervision (BCBS), in 2017.&nbsp; Importantly, the U.S. agencies are all active members of the BCBS and each played an important role in crafting the 2017 framework.It has been estimated that the proposal will increase large bank capital requirements by 20 percent or more.&nbsp; In this Capital Insights post, we will focus on one specific aspect of the heightened requirements – the negative impact these new capital rules would have on small business lending.&nbsp; Further, we will discuss how the U.S. capital proposal is out of step with proposals made by European Union (EU) and United Kingdom (UK) bank regulators to implement the 2017 Basel framework.<h3>Risk Weights for Investment Grade Corporate Loans &nbsp;&nbsp;</h3>Today, all corporate loans receive a “risk weight” of 100 percent.&nbsp; This means that if a bank has a capital requirement of, say, 10 percent, that bank would need to use $10 of equity capital to make a $100 loan.&nbsp; The other $90 would be sourced from a bank’s deposits.&nbsp; A risk weight of 50 percent would mean that the same bank could make the same $100 loan using only $5 in equity capital (and $95 in deposits).&nbsp; The risk weight assigned to corporate loans is important because as banks are required to use more equity capital, the cost of lending rises because equity capital is the most expensive form of finance.&nbsp; Loans requiring more equity capital are more expensive and less available than loans requiring less equity capital.&nbsp;&nbsp;The Basel framework and the recent U.S. proposal both make a change to the risk weight for corporate loans.&nbsp; Specifically, corporations and businesses that have a demonstrated ability to repay their loans can be classified as “Investment Grade” and receive a reduced risk weight of 65 percent rather than 100 percent.&nbsp; In the context of our earlier example, this would mean that a bank could make a $100 loan using $6.50 in equity capital rather than $10.00.&nbsp; In the chart below, we show the difference in required capital for an Investment Grade corporate loan both before and after the proposed change to the capital regime.<figure class="image"><img src="https://fsforum.com/a/media/picture4.png"></figure>In principle, this is a sensible and important change to the capital rules.&nbsp; All companies should not be painted with same brush.&nbsp; Financially responsible companies with a demonstrated ability to repay their debts are less risky and should require less equity capital.&nbsp; This clear link between “risk and return” is a bedrock principle of modern finance that should be reflected in bank capital requirements.&nbsp;<h3>Smart Policy is Poorly Executed in the Capital Proposal</h3>So far so good.&nbsp; Strong companies that are low risk can receive a lower risk weight of 65 percent and access bank financing on better terms, which makes a lot of sense.&nbsp; Where is the problem?The problem arises from a provision of both the Basel and U.S. proposals that severely limits the application of Investment Grade status to only the largest public companies.&nbsp; Specifically, the only companies that are eligible to be classified as investment grade are companies that have “publicly traded securities outstanding,” such as debt or equity securities (see page 89 of 1087 in the <a href="https://www.federalreserve.gov/aboutthefed/boardmeetings/frn-basel-iii-20230727.pdf">proposal</a>).This limitation is not motivated by any sensible risk considerations and is completely unnecessary for two reasons.&nbsp;First, there is no connection whatsoever between whether a company is high risk or low risk and whether it issues publicly traded securities.&nbsp; Publicly listed companies run the gamut from very conservative and low risk to the most speculative and risky of companies.&nbsp; A public listing is in no way a conclusive statement about underlying risk.&nbsp; And only the largest companies have the scale to issue public securities.&nbsp; At the same time, our economy is chock full of smaller companies that have borrowed and repaid many bank loans over an extended period.&nbsp; Why should these smaller companies with an established strong credit record be excluded from the Investment Grade designation? &nbsp;Second, smaller companies that do not have the scale to issue publicly traded securities are precisely the companies that rely most heavily on bank borrowing.&nbsp; And most companies in the United States are indeed small.&nbsp; According to the <a href="https://www.census.gov/data/tables/2020/econ/susb/2020-susb-annual.html">Census Bureau</a>, the U.S. economy has over 28 million companies and only about <a href="https://www.theglobaleconomy.com/USA/Listed_companies/">4,200</a> – or .015 percent – of these companies are publicly listed. &nbsp;&nbsp;As a result, denying smaller creditworthy companies access to better funding excludes the vast majority of U.S. companies and these firms don’t have as many alternative funding sources as do the very largest companies that are publicly listed.This unnecessary limitation will have the effect of creating a “two-tiered” credit system in which loans to creditworthy, public companies will require less capital than creditworthy small businesses as depicted in the chart below.&nbsp; As a result, bank lending to small businesses will be disadvantaged relative to lending to larger public corporations because smaller companies will be excluded from the investment grade classification.<figure class="image"><img src="https://fsforum.com/a/media/picture5.png"></figure><h3>Fixing The Mistake: Look Across the Pond</h3>Both the UK and the EU are also in the process of implementing the 2017 Basel reform.&nbsp; Both the UK and EU proposals are cognizant of the potential for this type of limitation to severely harm small businesses and have taken steps to ensure that small businesses are not denied Investment Grade status simply because of their smaller size.&nbsp; U.S. regulators should closely consider the proposals made by the EU and UK and find a way to ensure that creditworthy, small businesses in the U.S. have access to needed bank funding at reasonable cost.&nbsp;&nbsp; In addition to the disadvantage relative to U.S. public companies, small and mid-market companies in the U.S. will be disadvantaged relative to UK and EU companies, which means they could lose out on valuable business overseas.&nbsp; Our capital rules should not unnecessarily make it harder for U.S. companies to sell and grow through trade.&nbsp;&nbsp;<h3>Conclusion</h3>Small businesses are important to the vitality and dynamism of the U.S. economy.&nbsp; One key aspect of newly proposed bank capital rules would unnecessarily and unfairly increase the cost and decrease the availability of lending to small businesses.&nbsp; This result is not based on any sensible measure of risk and is not appropriate.&nbsp; European and UK regulators have recognized that this outcome is not sensible and have adjusted their implementation of the Basel capital framework to ensure creditworthy, smaller companies are not cut off from accessing bank financing at reasonable cost.&nbsp; The U.S. agencies should adjust their proposal to ensure that new bank capital rules do not unfairly and inappropriately disadvantage small businesses from accessing bank credit.&nbsp;&nbsp;&nbsp;

Capital Insights: New Bank Capital Rules Will Handicap Small Businesses 

Recently, the Federal Reserve, FDIC, and the Office of the Comptroller of the Currency issued a <a href="https://www.federalreserve.gov/newsevents/pressreleases/bcreg20230727a.htm">proposal</a> to substantially increase capital requirements for large U.S. banks.&nbsp; While there are many aspects of the proposal that are notable and will receive considerable attention over the coming months, one exceptionally notable aspect is the significant lack of consensus among voting principals at the regulatory agencies.&nbsp; At both the Federal Reserve and the FDIC there were two dissenting votes on the proposal.&nbsp; Further, while Federal Reserve Board Chair Jerome Powell voted for the proposal, his <a href="https://www.federalreserve.gov/newsevents/pressreleases/bcreg20230727a.htm">statement</a> made clear that he has a number of open and unresolved questions about the necessity and costs of significantly higher capital requirements.&nbsp;The last time the banking sector saw such a significant increase in capital requirements was when <a href="https://www.federalreserve.gov/newsevents/pressreleases/bcreg20130702a.htm">Basel III</a> was implemented in response to the financial crisis.&nbsp; Unlike the recent proposal, however, Basel III had unanimous support from agency principals.&nbsp; A capital hike of this magnitude would have substantial economic costs.&nbsp; As we have discussed in prior posts, independent <a href="https://www.piie.com/publications/working-papers/testing-modigliani-miller-theorem-capital-structure-irrelevance-banks">research</a> suggests that a capital increase of this magnitude could cost the U.S. economy as much as $ 1 trillion over the next thirty years.As Chair Powell stated, “raising capital requirements also increases the cost of, and reduces access to, credit.”&nbsp;The recent capital proposal is exceedingly lengthy and complex, coming in at over 1,000 pages, and, if implemented as written, could increase capital requirements by 20 percent or more.&nbsp; But despite the serious potential harm, regulators have made clear that they have yet to rigorously study the impact of the proposal on the banking sector and the broader economy.&nbsp; Clearly, a capital proposal of this size, complexity, and significance must be subjected to a rigorous and transparent cost-benefit analysis.&nbsp; A failure to rigorously examine the impacts of this proposal would be unacceptable given the stakes for our economy.&nbsp;To improve transparency, promote discussion and more generally demystify this complex and significant proposal, we are launching a blog series - Capital Insights - to identify and shed light on some of the most problematic and costly aspects of this proposal.&nbsp; The series will extensively, though efficiently, analyze key aspects of the proposal.&nbsp; Each blog will be focused on a single aspect of the capital proposal, the related costs, and the overall impact on the economy.&nbsp; Our inaugural blog in this new series will focus on the impact of the capital proposal on small businesses.&nbsp; Small businesses are crucial to the vibrancy of our economy and, unfortunately, this capital proposal would result in significant and unnecessary costs for small businesses that would place a drag on the economy.&nbsp; We will also address other key issues in the series including the impact on the ability of large companies to make needed investments, the ability of businesses to manage risks, and the impact on the competitiveness of U.S. banks.The recently released capital proposal has the potential to dramatically and negatively impact our banking industry and the economy.&nbsp; We look forward to bringing the proposal, and its consequences, into full view so that policymakers and the public better understand what it could mean for American families, businesses and future competitiveness. &nbsp;&nbsp;&nbsp;&nbsp;

Capital Insights: Demystifying the Consequences of Higher Capital Requirements

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Michael Chasen

Research Associate, Policy Research

It is well known that diversification in an investment portfolio lowers its risk. The same is true for a bank’s loan portfolio: a broad portfolio of various loan types is well diversified and lowers risk. Financial Services Forum members, the eight U.S. GSIBs (global systemically important banks), are among the most diversified banks in the country. Furthermore, with $899 billion in common equity tier 1 capital, more than triple the amount held in 2009, the nation’s largest banks are highly capitalized, acting as a source of stability for the U.S. economy as they have done both <a href="https://fsforum.com/news/federal-reserve-financial-stability-report-underscores-how-forum-members-support-financial-stability">throughout the pandemic</a> and <a href="https://fsforum.com/news/large-bank-capital-requirements-and-recent-bank-failures-why-one-has-nothing-to-do-with-the-other">in the most recent wave of bank failures</a>.&nbsp;&nbsp;In this blog, we use data from the FDIC’s <a href="https://www.fdic.gov/analysis/risk-review/2022-risk-review/2022-risk-review-full.pdf">2022 Risk Review</a>, the most recent available, to provide further evidence of the safety and stability of the largest U.S. banks by highlighting the exceptional diversification of their portfolios in three key loan markets: agriculture, commercial real estate (CRE), and housing. We also use data from first-quarter 2023 <a href="https://cdr.ffiec.gov/public/PWS/DownloadBulkData.aspx">bank reports</a> to demonstrate that risk concentrations in these loan markets tend to increase as bank asset sizes decrease, demonstrating that large banks are far less likely to contain heavy concentrations of risk in their portfolios. Accordingly, while recent concerns about a souring commercial real estate market are not without merit, these developments are unlikely to have a material negative impact on Forum members due to their low concentrations and high degree of diversification.&nbsp;<h3>Real Estate Loan Concentration and the 2022 FDIC Risk Review&nbsp;</h3>The FDIC considers a bank’s real estate lending portfolio to be highly concentrated and therefore high risk if the total exposure to a single type of loan is greater than three times the bank’s total tier 1 capital. For example, a bank with $300 billion in agricultural loans and only $100 billion in tier 1 capital would be considered ‘highly concentrated’ in agricultural lending. In Table 1, we show the percentages of all U.S. banks with high-risk concentrations in three important loan markets as measured by the FDIC, and the percentages of Forum members with high concentrations in the same markets.&nbsp;Table 1: Risk Concentrations Among U.S. Banks and Financial Services Forum Members&nbsp;<figure class="table"><table><tbody><tr><td>&nbsp;</td><td>Agriculture&nbsp;</td><td>CRE&nbsp;</td><td>Housing</td></tr><tr><td>% of all banks with exposure &gt;300% Capital (%)&nbsp;</td><td>5</td><td>27</td><td>10</td></tr><tr><td style="height:10px;width:700px;">% of Forum members with exposure &gt;300% Capital (%)&nbsp;</td><td>0</td><td>0</td><td>0</td></tr></tbody></table></figure>Source: FDIC <a href="https://www.fdic.gov/analysis/risk-review/2022-risk-review/2022-risk-review-full.pdf">2022 Risk Review</a> &amp; FR Y-9 Data&nbsp;&nbsp;While 5 percent of U.S. banks are highly concentrated in agriculture, 27 percent in CRE, and 10 percent in housing, none of the U.S. G-SIBs exhibits a high concentration in any of these markets, showing that Forum members contain both healthy levels of tier 1 capital and broadly diversified lending portfolios.&nbsp;&nbsp;In Table 2, we extend the analysis to look at the average level of loan concentration in each market for banks of different sizes to demonstrate how lending concentrations are distributed throughout the banking sector. As before, the loan concentration reported in the table is defined as the average exposure to each loan type (agricultural, CRE, residential) measured as a percentage of tier 1 capital. As an example, a CRE risk concentration of 50 means that banks in that asset category have, on average, an exposure to CRE that is 50 percent as large as the amount of tier 1 capital maintained by banks in that asset category.&nbsp;Table 2: Risk Concentrations Among U.S. Banks by Asset Size&nbsp;<figure class="table"><table><tbody><tr><td>Asset Size($ billions)</td><td>Agriculture</td><td>CRE</td><td>Housing</td></tr><tr><td>250 +</td><td>2</td><td>47</td><td>26</td></tr><tr><td>100-250</td><td>1</td><td>67</td><td>65</td></tr><tr><td>50-100</td><td>4</td><td>211</td><td>78</td></tr><tr><td>10-50</td><td>9</td><td>229</td><td>87</td></tr><tr><td>5-10</td><td>16</td><td>230</td><td>100</td></tr><tr><td>&lt;5</td><td>78</td><td>175</td><td>57</td></tr></tbody></table></figure>Source: <a href="https://cdr.ffiec.gov/public/PWS/DownloadBulkData.aspx">2023Q1 Call Report Data</a>&nbsp;As shown in Table 2, banks with greater than $250 billion in total assets exhibit the smallest average risk concentration in both commercial real estate and housing. They also exhibit the second smallest average risk concentration in agricultural loans, just behind banks with $100 billion to $250 billion in total assets. As banks decrease in size, the average concentration in all three markets increases, and eventually peaks for banks with less than $10 billion in total assets. Thus, while the largest banks hold an average concentration of 47 percent in CRE, far below the 300 percent marker, banks with less than $10 billion in assets have an average concentration of 230 percent, demonstrating that large banks are the most diversified.&nbsp;<h3>Conclusion&nbsp;</h3>The largest banks in the United States are resilient and well diversified, acting as a source of strength and stability for the U.S. economy. As we have demonstrated, highly concentrated loan portfolios, which increase risk in the banking industry, tend to be found among banks of smaller asset sizes rather than their larger counterparts. Policymakers and regulators looking to decrease risk in the banking system should take these facts into consideration and avoid penalizing banks that are both highly diversified and well capitalized.&nbsp;&nbsp;

FDIC Risk Review: The Largest Banks Remain Well Diversified 

It is expected that bank regulators will soon release a proposal to raise capital requirements for the largest U.S. banks.&nbsp; The proposal is expected to increase capital for the largest U.S. banks substantially, by as much as <a href="https://www.wsj.com/articles/big-banks-could-face-20-boost-to-capital-requirements-c68c1e1b">20 percent</a>.&nbsp; All of this comes at a time, however, when the largest banks are already exceptionally well capitalized.&nbsp; Indeed, Federal Reserve Chair Jay Powell has characterized the capital level of U.S. GSIB banks – all Forum members – as being at “<a href="https://www.regreport.info/2022/01/11/powell-seeking-reappointment-says-big-bank-capital-at-multidecades-high-vows-to-earn-trust/">multi-decade highs</a>.”&nbsp; More recently, the Federal Reserve Board in its <a href="https://www.federalreserve.gov/publications/files/financial-stability-report-20230508.pdf">Financial Stability Report</a> found that “as of the fourth quarter of 2022, banks in the aggregate were well capitalized, especially U.S. global systemically important banks.”&nbsp; In light of the current strong capital and resilience of Forum members it is difficult to understand the zeal to continually raise capital standards for U.S. GSIBs.&nbsp; In this blog we discuss some of the flawed arguments for excessively raising capital and some of the consequences that would come from additional and unnecessary increases in Forum member capital requirements.<h3>Confusing Levels with Changes</h3>A common rational for increasing capital requirements is some form of “strong banks make for a strong economy,” which essentially argues that banks with strong capital positions are in a good position to lend to and support the economy.&nbsp; There is, of course, some truth to that point of view, but no one should confuse the statement that “banks with high capital promote a strong economy” with “banks with higher capital promote a stronger economy.”&nbsp; As a matter of pure logic, the first statement in no way implies the second.&nbsp; More importantly, as in almost all things in life, more is not always better.&nbsp; The examples proving this fundamental truth are too numerous to list and come from all walks of life.&nbsp; A sea wall of modest height along a beach stops erosion and protects the coast from severe storms.&nbsp; Building the sea wall to several stories is prohibitively costly, offers little additional protection, and creates an eyesore that blocks the view of the ocean for everyone.&nbsp; Every economy needs to save to finance investment and grow, but too much savings in an economy thwarts consumption and places a drag on growth.&nbsp; Simply put, you can indeed have too much of a good thing and striking appropriate balance is paramount.In the context of capital, the right analytical framework is to consider the marginal benefits of increasing capital.&nbsp; Capital, like almost everything else, is subject to the law of diminishing returns. Every additional dollar of bank capital increases bank resiliency, but the next dollar of capital always improves resiliency by less than the previous dollar.&nbsp; At some point you hit the point of “enough is enough” because additional capital adds very little resilience while exacting a cost to the economy in terms of higher borrowing costs and reduced credit availability.&nbsp; U.S. GSIBs have tremendously increased high-quality capital by more than a factor of three in the past fifteen years.&nbsp; As shown in the figure below, common equity capital for Forum members now stands at roughly $900 billion.&nbsp; When evaluating whether more capital will improve the financial system, one has to begin with the current level of bank capital and ask – in light of the current high level, will an increase in capital be beneficial?&nbsp;&nbsp;&nbsp;<figure class="image"><img src="https://fsforum.com/a/media/screen-shot-2023-06-21-at-6.18.30-am.png"><figcaption>Source: Federal Reserve Y-9C</figcaption></figure>&nbsp;Thankfully, economists have been actively considering this issue for some time.&nbsp; A recent <a href="https://www.pwc.com/us/en/industries/financial-services/library/basel-iii-endgame.html">study</a> by PwC examined the academic literature on the “optimal” level of bank capital, finding that existing and already high levels of bank capital at the largest U.S. banks are in line with the findings of academic economists.&nbsp; As stated by the authors: “the optimal capital range is 12-19.5%, with an average of 15.5%.&nbsp; This figure aligns closely with the actual tier 1 bank capital ratios of 15.5% and 15.2%, as of the fourth quarter of 2021 and 2022.”&nbsp; A blanket pronouncement that increasing capital is justified based on the notion that “strong banks make for a strong economy” is conceptually flawed because it confuses the argument that robust capital levels are important with the argument that increasing capital levels will be beneficial while ignoring the already robust level of capital for our largest banks. Further increases in capital for the largest U.S. banks are unnecessary and will exact an unnecessary and avoidable toll on the U.S. economy.&nbsp;&nbsp;&nbsp;&nbsp; &nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;<h3>The Conceptual Switcheroo of “Reduced Variability”</h3>The pending capital proposal was originally motivated by regulators in an effort to reduce the variability of capital requirements across banks while providing greater transparency.&nbsp; Indeed, Governor Philip Jefferson of the Federal Reserve recently gave a <a href="https://www.federalreserve.gov/newsevents/speech/jefferson20230531a.htm">speech</a> where he cited this as a key rationale for the new capital proposal.However, addressing capital variability does not require or justify requiring banks to maintain more capital. &nbsp;&nbsp;First, it has been reported that the capital proposal could raise capital requirements by as much as 20 percent.&nbsp; There is absolutely nothing about reducing variability in capital requirements that would be expected to result in a material increase (or decrease) in capital requirements.&nbsp; Capital variability is reduced by removing outliers that result in either very high or very low capital requirements.&nbsp; If both extreme highs and lows are removed, the overall level of capital should remain largely unchanged.&nbsp; Arguing that the main motivation for revising capital requirements is to “reduce excess variability” while those revisions are expected to increase capital by 20 percent is a conceptual switcheroo.Second, significant variability in capital levels of individual banks is largely driven by the use of internal bank models for computing required capital.&nbsp; Different banks employing different assumptions in their models, rightly or wrongly, will result in differing capital requirements.&nbsp; The use of internal models for capital purposes is almost entirely an issue for European banks and not U.S. banks.&nbsp; For over a decade, U.S. bank capital requirements have been determined through the use of “standardized” approaches, which prohibit the use of bank internal models.&nbsp; Accordingly, there is very little scope for U.S. banks to generate variability in their capital requirements because they are largely prohibited from employing the kinds of internal models that are regularly employed by European banks.&nbsp; Accordingly, the goal of reducing excess capital variability must be achieved largely through the regulation of internal models employed by European banks. &nbsp;<h3>The Fallacy of “Long Transition Periods”</h3>When confronted with the clear and obvious costs of further capital increases, some respond by stating that the costs can be managed because banks will be given “a long time” to come into compliance.&nbsp; This argument is both incorrect and disingenuous because it ignores recent experience with capital regulation.When capital requirements change, bank analysts and other market participants immediately assess the impact on the banking sector and hold banks to these new and higher standards.&nbsp; In turn, banks move expeditiously to comply with the new and higher requirements to demonstrate their overall strength and resilience.&nbsp; The fact that the rule allows for more time to comply as a regulatory matter is simply irrelevant.This fact was clearly demonstrated during the earlier stages of the post-crisis Basel III reforms.&nbsp; Specifically, <a href="https://www.clevelandfed.org/publications/working-paper/2022/wp-2211-the-impact-of-the-basel-iii-reforms-in-the-united-states">research</a> from the Federal Reserve showed that banks began complying with the requirements for Basel III even before the Basel III rule had been finalized in the U.S.&nbsp; As the authors put it, "bank responses we estimate take place well before the Basel III rules started to come into force after 2014.”&nbsp; The importance of this point cannot be overstated.&nbsp; The well-documented fact hat banks were “pulling forward” new capital requirements even before the ink was dry on the final Basel III requirements clearly shows that any claim that a “long transition period” will blunt the costs of increased capital regulation is without any theoretical or empirical basis. &nbsp;&nbsp;<h3>Conclusion</h3>Forum members have collectively more than tripled their capital levels over the past fifteen years.&nbsp; The events of the past few years – whether the pandemic or the regional bank turmoil – have clearly demonstrated the strength of Forum members’ capital positions.&nbsp; Consequently, there is no compelling reason for a further significant increase in capital for Forum members.&nbsp; Moreover, regulators have yet to provide any clear or convincing case for any capital raise for the largest U.S. banks.&nbsp; Arguments that have been provided such as “strong banks make for a strong economy” or “the revised capital framework will reduce excess capital variability” either ignore the already robust level of capital or are at odds with the fundamental facts surrounding the planned hike in capital.&nbsp; Unnecessarily increasing capital will necessarily result in large costs for the economy in terms of increased borrowing costs and reduced access to credit without any significant improvement in resiliency.&nbsp; Finally, the notion that stretching out the timeline for compliance will ameliorate these large costs ignores well-known and well-documented realities of how quickly the financial sector adjusts to new regulatory requirements.&nbsp; Regulators and the public should carefully and seriously consider the level of capital for U.S. GSIBs and the economic impact of any further increases before proposing any new requirements.

Too Much of a Good Thing: Unnecessarily Raising Capital Requirements on the Largest Banks Will Exact a Real Economic Toll 

<h3>Introduction</h3>In a&nbsp;<a href="https://financialservices.house.gov/calendar/eventsingle.aspx?EventID=408768">hearing</a>&nbsp;on Tuesday focused on recent failures of regional banks, banking regulators repeated their&nbsp;<a href="https://financialservicesforum.cmail20.com/t/r-i-ttjiduky-l-t/">intention</a>&nbsp;to propose new capital rules for banks who have been a source of strength in recent months, the U.S.-based Global Systemically Important Banks, or GSIBs.&nbsp;These new requirements are expected to significantly increase capital requirements for these banks.A new report, <a href="https://www.pwc.com/us/en/industries/financial-services/library/basel-iii-endgame.html#:~:text=Basel%20III%20Endgame%20is%20a,%2Dweighted%20assets%20(RWA)">Basel III Endgame: The next generation of capital requirements</a>, sheds important light on the state of large bank capital in the United States.&nbsp; The findings from PwC, the global audit and consulting firm, are helpful for assessing both the current state of capital at the largest U.S. banks and any potential need for additional capital.&nbsp; In this blog, we provide a brief overview of the PwC report and its key findings.&nbsp; Overall, the report shows that 1) capital and resiliency at the largest U.S. banks is strong, 2) the level of capital maintained by the largest U.S. banks is in line with academic findings on the optimal level of bank capital, 3) increasing capital requirements on this group of banks will impose a direct cost on the economy, and 4) raising bank capital requirements will hasten the migration of activity from the banking sector to the less regulated non-bank sector and impair financial stability.&nbsp; The report and its findings should be seriously reviewed and considered by policymakers as they consider new capital rules for the nation’s largest banks.&nbsp; On balance, the report strongly suggests that any new capital requirements would incur more costs than benefits to the economy.<h3>The Largest U.S. Banks are Well Capitalized and Resilient</h3>Since the financial crisis, U.S.-based Global Systemically Important Banks (GSIBs), have increased their capital levels substantially. As the report shows in the chart below, common equity tier 1 capital (CET1), the highest quality of regulatory capital, has more than tripled to $881 billion.&nbsp;<figure class="image"><img src="https://fsforum.com/a/media/screen-shot-2023-05-16-at-4.08.42-pm.png"><figcaption>Source: Basel III Endgame: The next generation of capital requirements</figcaption></figure>&nbsp;And while the report clearly documents the significant and notable rise in capital at the largest U.S. banks, it also outlines the substantial improvements in resiliency through other, non capital-related initiatives, such as liquidity requirements, total loss absorbing capacity (TLAC) requirements, and a host of other important regulatory initiatives.&nbsp; Importantly, the authors note that understanding and accounting for these additional sources of resiliency are crucial when evaluating the “right” level of capital for the banking system because these other initiatives support and complement capital requirements.&nbsp; As an example, the chart below from PwC clearly demonstrates the large increase in liquidity resources from roughly $500 billion to nearly $3 trillion– or more than a six-fold increase – that supports and buttresses capital requirements.&nbsp;<figure class="image"><img src="https://fsforum.com/a/media/screen-shot-2023-05-16-at-4.08.57-pm.png"><figcaption>Source: Basel III Endgame: The next generation of capital requirements</figcaption></figure>&nbsp;&nbsp;<h3>Capital at the Largest Banks Consistent with Academic Research on “Optimal” Levels</h3>The new report also offers an important review of academic studies on the optimal level of capital in the banking system.&nbsp; This is an important part of the report because while documenting the significant increase in capital and resiliency is important, ultimately, we need a coherent analytical framework to assess “how much is enough?”The report reviews a broad range of relatively recent academic research on this topic.&nbsp; And importantly, the report reviews academic studies that consider a “broad range” of post-crisis regulations (e.g., TLAC, liquidity requirements) because of the inherent importance of considering the entire regulatory framework when assessing the optimal level of bank capital.&nbsp; The chart below summarizes the findings.&nbsp;&nbsp;<figure class="image"><img src="https://fsforum.com/a/media/screen-shot-2023-05-16-at-4.09.11-pm.png"><figcaption>Source: Basel III Endgame: The next generation of capital requirements</figcaption></figure>&nbsp;As shown in the chart and stated in the report, “the average optimal capital level that the papers suggest is near current levels at firms expected to be subject to Basel III Endgame capital requirements.”&nbsp; Moreover, it is worth noting that the average optimal capital level is “pushed up” by the results of a study from the Federal Reserve, which finds an optimal ratio of 20 percent, substantially higher than the findings of all other academic studies considered in the report.&nbsp; Accordingly, statements that large bank capital levels are inconsistent with the findings of academic research are simply incorrect.<h3>Increasing Capital at the Largest U.S. Banks will Impose Direct Costs on the Economy, Hasten the Migration of Activity to Non-Banks, and Impair Financial Stability</h3>In addition to documenting the resilience and capital adequacy of the largest U.S. banks, the report also provides important evidence on the impact of increasing capital standards on these institutions.&nbsp; Specifically, the report recognizes two key drawbacks to inappropriately high capital requirements: 1) higher borrowing costs for businesses and consumers, and 2) increased migration of banking activities outside the banking sector.In terms of the direct costs of increasing capital, the report points to a range of research, finding, “greater capital requirements increase a commercial bank’s funding costs, which increases its lending rates and reduces its loan volumes,” thus reducing economic activity.&nbsp; As an example, one of the papers reviewed in the report finds that increasing the risk-based capital ratio by two percentage points (e.g., increasing the requirement from 10 percent to 12 percent) would increase the cost of borrowing by roughly a quarter percentage point and reduce GDP by roughly a quarter percentage point.The report also considers the impact on the economy via a migration of activity outside the banking sector.&nbsp; More specifically, the report finds that non-banks may expand as a result of higher bank capital requirements pushing activity outside of the banking sector and may increase the chances of financial crises, “The potential increase in probability of a crisis would be driven by greater leverage in less regulated and less transparent financial intermediaries, and the potential increase in cost would be due to resiliency of the credit supply being reduced.” &nbsp;&nbsp;<h3>Conclusion</h3>PwC’s report on the largest U.S. banks provides a lot of important food for thought for regulators as they consider proposing higher capital requirements for the largest U.S. banks.&nbsp; Overall, the report finds that resiliency at the largest banks has been strengthened considerably and is at levels broadly consistent with recommendations offered by independent research studies.&nbsp; The report also rightly points to the costs of inappropriately increasing capital requirements – both in terms of the direct costs and the financial stability costs of an expanded non-bank sector.&nbsp; The Federal Reserve is conducting a “holistic review” of bank capital.&nbsp; The PwC report serves as an excellent template for such a review.&nbsp; The report is data-based, draws on a broad array of academic research, and, importantly, is fully public and transparent.&nbsp; The data, methods, and analysis contained in the report and its conclusions can be reviewed by anyone.&nbsp; We believe that the Federal Reserve should make its holistic review as open and transparent as the PwC report.&nbsp; Based on the findings, there is no convincing evidence to suggest that the largest U.S. banks are in need of more capital and increasing requirements would come at a cost.&nbsp; If the Federal Reserve holds a different view, it should be willing to provide its findings in a clear, open, and transparent manner before moving ahead with any policy prescriptions.&nbsp;&nbsp;&nbsp;&nbsp;

A Holistic Review of Large Bank Capital: Findings from a New Report

Large U.S. banks are subject to stricter capital requirements and maintain more equity capital on their balance sheet than their European competitors. Over time, internationally agreed-upon capital rules have been implemented more stringently in the United States than in Europe. As a result, and quite perversely, international efforts to create a level playing field have resulted in an unlevel one.&nbsp;Regulators around the globe are now engaged in implementing another round of internationally agreed-upon capital reforms, known as Basel 3 Finalization. And once again, there are clear signs that U.S. regulators will implement these reforms more stringently than other regulators, further widening the capital disparity between large U.S. and European banks. In this post, we document the existing capital disparity between large U.S. and European banks and then discuss the implications for further regulatory tightening by U.S. regulators. Unnecessarily tighter capital regulation in the U.S. will increase the cost of lending by U.S. banks while diminishing their ability to compete with their foreign competitors.&nbsp;&nbsp;&nbsp;<h3>A Comparison of U.S. and European Large Bank Risk-Based Capital Requirements</h3>Large, internationally active banks are all subject to capital requirements that are informed by internationally negotiated standards and are set forth by the Basel Committee on Banking Supervision.&nbsp; Capital is a critical resource for banks, ensuring that they can absorb losses associated with lending, other services, and changes in the economy. But capital is an expensive form of bank funding. The Basel committee was formed in 1975 for the purpose of creating bank regulatory standards that are consistent across member jurisdictions. Once standards are adopted by Basel, each country codifies those standards into regulation at the national level.Figure 1 below compares the weighted average risk-based capital requirement – in percentage terms – that applies to the eight members of the Financial Services Forum as well as 12 large banks headquartered in Europe – the UK (3), Switzerland (1), and the European Union (8). Each of these institutions is designated as a Global Systemically Important Bank (GSIB). The figure displays the overall level of required capital as well as the constituent components.&nbsp;&nbsp; &nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;<figure class="image"><img src="https://fsforum.com/a/media/screen-shot-2023-05-03-at-7.37.47-pm.png"><figcaption>Source: Federal Reserve Y-9C, Company Annual Reports</figcaption></figure>&nbsp;As shown in the figure, large U.S. banks are subject to a risk-based capital requirement of 11.3 percent versus a requirement of 9.9 percent for large European banks. As Basel capital regulation is intended to create equal standards across jurisdictions, one is led to ask – why are capital standards so much higher in the U.S.?U.S. capital requirements are higher in the U.S. primarily for two reasons.&nbsp; First, the eight U.S. GSIBs are subject to a higher GSIB surcharge – an additional capital charge for GSIBs – than those in Europe, because the Federal Reserve applied a surcharge that is tougher than the Basel GSIB standard. In the left-hand bar chart, we show that the higher GSIB surcharge (Additional U.S. GSIB) results in an additional 1.0 percent requirement. Second, large U.S. banks are subject to the Federal Reserve’s stress tests, which are then translated into a bank-specific stress capital buffer (SCB). Large U.S. banks are subject to an average SCB of 4.1 percent. Prior to the adoption of the SCB by the Federal Reserve, large U.S. banks were subject to a 2.5 percent capital conservation buffer (CCB) that is prescribed by Basel and applied also to large European banks. As a result, the SCB results in an additional requirement of 1.6 percent (Additional SCB) that does not apply to European banks.&nbsp;It should be noted that large European banks are subject to an additional set of Pillar 2 capital requirements that are not applied to U.S. banks. Still, the punitive nature of both the U.S. GSIB surcharge and SCB result in required capital for large U.S. banks that is 1.4 percentage points higher than that required of large European banks. In dollar terms, U.S. GSIBs are required to hold $100 billion more capital than their European competitors due to these more stringent requirements.<h3>A Comparison of U.S. and European Large Bank Equity Capital Levels</h3>An analysis of U.S. and European capital standards is informative, but how do these different capital standards translate into the amount of equity capital maintained by large U.S. and European banks?&nbsp; After all, banks typically maintain equity capital beyond their regulatory requirements to have a prudent cushion, and they consider a host of other factors, such as market conditions and the state of the economic cycle, in determining how much equity capital to maintain on their balance sheets.Figure 2 displays the ratio of equity capital (Total Assets – Total Liabilities) to total assets for large U.S and European banks. These ratios account for well-known, but technical differences in how U.S. and European banks report their total assets. Also, these ratios are based on total asset measurements that do not account for risk. As a result, these ratios cannot be directly compared to the risk-based requirements described above, but are informative for assessing the overall amount of equity maintained by each group of banks.&nbsp;<figure class="image"><img src="https://fsforum.com/a/media/screen-shot-2023-05-03-at-7.38.00-pm.png"><figcaption>Source: Federal Reserve Y-9C, Company Annual Reports</figcaption></figure>&nbsp;As shown in the figure, U.S. GSIBs maintain 8.1 percent of total assets in equity capital as opposed to 5.7 percent for large European GSIBs. This clearly demonstrates that the higher requirements set by U.S. regulators directly translate into higher amounts of equity capital maintained by large U.S. banks.&nbsp;<h3>The Further Tilting of the Unlevel Playing Field</h3>As we have documented, large U.S. banks are subject to more stringent capital requirements and maintain more equity capital on their balance sheets than large European banks. This disparity directly contributes to competitive inequity because banks with lower capital requirements can fund their lending cheaper and undercut banks subject to more stringent requirements.The central aim of Basel III Finalization was to increase the quality and quantity of European bank capital to improve the competitive landscape. However, the European Union is proposing to implement these reforms in a manner that deviates from the Basel standards. More specifically, the <a href="https://www.eba.europa.eu/sites/default/documents/files/document_library/Publications/Reports/2022/Basel%20III%20monitoring%20report/1039929/Annex%20-%20EU%20specific%20analysis.pdf">European Banking Authority</a> estimates that the EU approach will result in 3.2 percentage points less capital than would be achieved if the reforms were implemented in line with the Basel agreement.&nbsp;If the U.S. implements Basel III Finalization in a way that is more stringent than that adopted by the EU, the competitive inequities will be worsened, and there will be significant and unnecessary costs to the U.S. economy. In particular, the cost of bank lending by U.S. banks will rise while eroding their ability to compete with their foreign competitors. U.S. regulators can implement the standards in a way that avoids these results. And given the obvious strength and resilience of the largest U.S. banks, it has every reason to do. &nbsp;

U.S. vs. European Capital Adequacy - The Increasingly Unlevel Playing Field Unfolding in Basel III Finalization

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Kevin Fromer

President and Chief Executive Officer

The rapid and disorderly failures of Silicon Valley, Signature, and Silvergate banks last month quickly unleashed calls for more bank regulation, before there was time to even begin an assessment of what had taken place. Hopefully, informed policymakers will let careful review of the facts and issues be the basis for any targeted recommendations that the public can consider and debate.&nbsp;During this period, the strength of the largest U.S. banks – which are subject to the most stringent regulation and supervision – has never been in doubt. In fact, as they did during the pandemic, the nation’s largest banks have acted as a source of strength and supported the broader banking sector to avoid further turmoil and cost to the economy.Recent bank failures have been characterized by a classic “bank run” dynamic in which a lack of liquidity was the key source of vulnerability. In the case of Silicon Valley Bank (SVB), the first line of defense was the management itself, followed by supervisory oversight, to ensure that as the bank grew rapidly, its management had the information and judgment to manage its unique deposit profile and customer base, it had adequate liquidity, and eventually, access to capital.Only thorough reviews by authorities, independent arms like the GAO, and oversight committees of Congress will help reveal if additional requirements might have prevented these bank runs. A clear focus will be on liquidity risk – or the need to manage the duration and liquidity profile of a bank’s assets and liabilities – which is the most fundamental risk in banking. Such risk is addressed by a set of requirements that are designed to regulate and inform bank management’s assessment of its ability to meet its liquidity needs. But liquidity risk is wholly unrelated to the risk that is targeted by capital regulation – credit risk. The largest U.S. banks meet the most stringent liquidity and capital requirements. They are also subject to the strictest and most stringent supervisory program on an ongoing basis.Even though the collapse of SVB and Signature Bank had nothing to do with the existing capital regime for large banks, there are some who simply respond by saying that more capital solves any problem. However, the capital standards that apply to the largest U.S. banks never applied to these or similarly sized banks. Notably, when the Biden administration called for changes to the bank regulatory regime, none was suggested for the largest banks.Despite this, U.S. regulators are considering changes to large bank regulation, including the final elements of the Basel capital reforms, on top of an already robust capital framework to which the largest U.S. banks fully adhere. Final Basel reforms were first contemplated before our nation’s largest banks had been tested through a real-life stress test of the pandemic, and more recently, a period of significant uncertainty in the banking sector. Throughout it all, the nation’s largest banks have been a source of strength and proven their resilience. Consequently, the onus should be on regulators to prove an increase in capital is necessary or wise for the largest U.S. banks, given the inevitable negative impact on the costs of lending and the real economy, and the continued migration of risk to the less regulated non-bank sector. Over the next several months, making the right choices for borrowers, savers and the economy will be critical.&nbsp;<blockquote>The Difference Between Capital and LiquidityImportantly, requirements for liquidity and capital are distinct. Liquidity is the cash and other assets banks have available to quickly meet short-term business and financial obligations. Capital encompasses the resources banks maintain to absorb losses in times of stress and continue to serve customers, clients, and communities. <a href="https://www.federalreserve.gov/faqs/cat_21427.htm">Learn more</a>.</blockquote>&nbsp;&nbsp;

Large Bank Capital Requirements and Recent Bank Failures – Why One Has Nothing to Do with the Other

<h3>Introduction</h3>During the pandemic, Financial Services Forum members displayed significant strength and provided support to the economy by providing much-needed lending to businesses and households, helping firms raise capital through public securities offerings, and providing consumers with a place to keep their money safe during a period of heightened uncertainty. &nbsp;In looking back at the pandemic, some have argued that given broad government support for the economy, COVID was not a true test of the banking system’s resiliency.&nbsp; In this post, we analyze the impact that counterfactually high COVID losses absent government intervention would have had on Forum members.&nbsp; The analysis shows that even in the face of counterfactually high hypothetical losses Forum capital levels would have remained robust, allowing them to support the economy during the pandemic.&nbsp; &nbsp;<h3>The Calm Before the Storm: Large Bank Capital on the Eve of the Pandemic</h3>On the eve of the COVID pandemic, the fourth quarter of 2019, Financial Services Forum members maintained an aggregate common equity Tier 1 capital ratio of 12.1 percent.&nbsp; Before discussing the events of the pandemic, it is instructive to assess the significance and robustness of that level of capital.&nbsp; In particular, Forum capital levels reflected a 4.5 percent minimum requirement that was established after the financial crisis as well as a variety of capital buffers relating to the Federal Reserve’s stress tests and other regulatory requirements, such as the GSIB capital surcharge, that are intended to ensure that Forum members maintain capital well beyond the amount needed to operate during both normal and stressed economic conditions.&nbsp; These capital buffers are intended to flexibly expand and contract in response to underlying economic conditions and are not rigid requirements that are fixed for all time.&nbsp;&nbsp;&nbsp; &nbsp;In Figure 1, we display the required regulatory minimum and pre-COVID capital levels to visually demonstrate the strong and robust level of capital maintained by Forum members before the onset of the pandemic.&nbsp; The figure clearly demonstrates that Forum members were well positioned to support the economy despite the unanticipated economic turmoil stemming from the pandemic.&nbsp; &nbsp;<figure class="image"><img src="https://fsforum.com/a/media/screen-shot-2023-02-22-at-3.44.44-pm.png"><figcaption>Source: Federal Reserve Y-9C</figcaption></figure>&nbsp;<h3>Large Bank Capital and Counterfactually High COVID Losses</h3>As COVID shut down the U.S. economy in the first quarter of 2020, banks suffered losses and their balance sheets expanded as they absorbed deposits and extended credit to support the economy.&nbsp; As a result, bank capital ratios declined from 12.1% to 11.4% - the low point of Forum member capital during the pandemic.&nbsp; While this decline represents an economic loss, large banks exhibited double digit capital levels, reaffirming their resiliency.&nbsp; Indeed, the reduction in capital simply reflected a modest compression of the ample capital buffers that were established after the financial crisis.Some have argued that these losses do not represent the “true” economic losses attributable to the pandemic because of government support.&nbsp; While banks received no direct government support during the pandemic, some have argued that broad support provided throughout the economy – extended unemployment benefits, CARES act stimulus, and the like – buoyed household finances and forestalled loan defaults that would have otherwise hit the banking sector.In order to seriously consider these claims, one needs to provide a specific and quantitative estimate of those counterfactual losses.&nbsp; Such counterfactuals are, by their very nature, hard to assess.&nbsp; How can anyone validate a loss estimate that never occurred based on assumptions that were not realized?&nbsp; Conceptual difficulties aside, it is instructive to consider some estimates of counterfactual losses to see what impact they would have had on large bank capital levels.One analysis conducted by the <a href="https://www.minneapolisfed.org/article/2021/government-fiscal-support-protected-banks-from-huge-losses-during-the-covid-19-crisis">Federal Reserve Bank of Minneapolis</a> suggests that banking industry losses would have been $100 billion to $300 billion higher in the absence of government support.&nbsp; Our use of these estimates is intended to be instructive but is not intended to convey agreement with the findings.In Figure 2 below, we show the aggregate Forum member capital ratio that would have been realized had these counterfactual losses – either $100 billion or $300 billion scaled to reflect the size of Forum members relative to the entire industry – occurred in the first quarter of 2020.&nbsp; This calculation is highly conservative because we are assuming that all of the losses would have been realized in a single quarter, and we are also assuming that the losses would have occurred when Forum member capital was at its lowest point during the pandemic (Q1 of 2020).&nbsp; Had those counterfactual losses occurred more smoothly over the course of 2020, the impact on capital would be significantly smaller.&nbsp;<figure class="image"><img src="https://fsforum.com/a/media/screen-shot-2023-02-22-at-3.45.00-pm.png"><figcaption>Source: Federal Reserve Y-9C, Federal Reserve Bank of Minneapolis</figcaption></figure>&nbsp;&nbsp;As shown in Figure 2, these counterfactual losses would have reduced Forum member aggregate capital from 11.4% to between 10.7% ($100 billion) and 9.2% ($300 billion).&nbsp; This level of capital is still quite robust, being more than twice the post-crisis regulatory minimum of 4.5%.&nbsp; It is reasonable to assume that banks need to maintain capital above the regulatory minimum requirement.&nbsp; It is clear, however, that operating with a level of capital that is more than twice the post-crisis regulatory minimum would be sufficient to continue operating soundly while maintaining public confidence.&nbsp; While higher COVID economic losses would have resulted in lower capital levels, and may have required some amount of capital to be rebuilt over time, the resulting counterfactual capital levels are not anywhere near a level that could be reasonably described as problematic or distressed.This point has also been publicly made by Federal Reserve Chair Jerome Powell.&nbsp; Specifically, during a <a href="https://www.youtube.com/live/-46kqEn6JLc?feature=share&amp;t=4616">Senate hearing in 2021</a>, Chair Powell disputed an assertion that banks would have been materially weakened by an additional $300 billion in COVID losses.&nbsp; Chair Powell responded: “which they would have met.&nbsp; Which they would have been able to absorb without difficulty.” (emphasis added)<h3>Addressing the Cassandras – Root Risk Analysis in Reality&nbsp; &nbsp;&nbsp;</h3>The analysis above and the statements of Chair Powell clearly document that Forum members would have remained resilient during the pandemic even if bank losses were unrealistically elevated relative to actual experience.&nbsp; But what if losses were $600 billion or $900 billion or even $1 trillion?&nbsp; What if the elevated losses carried into 2021, and 2022, and 2023 as well?&nbsp; What if the virus had become significantly more virulent and resulted in multiyear and economically devastating lockdowns?As a matter of basic arithmetic, it is always possible to dream up an implausibly extreme, counterfactual scenario that would substantially weaken bank capital to unstable levels.&nbsp; But that exercise tests nothing except one’s ability to count.&nbsp; Rigorous and informative risk analysis demands that the scenario be within the bounds of reason given the prevailing economic context.&nbsp; Counterfactually high pandemic losses would have reduced capital levels, but capital would have remained sufficiently strong to avoid any significant financial distress.&nbsp; Of course, one should “never say never” when it comes to risk.&nbsp; But simply asserting that losses could have reached a level that would have destabilized the banking system is a tautology with no empirical content that says nothing about the safety and soundness of large banks.&nbsp;&nbsp;&nbsp;<h3>Conclusion</h3>Forum members steadfastly supported the economy during the depths of the COVID pandemic.&nbsp; Their ability to support our economy stems from their strong capital position.&nbsp; No large banks received direct government assistance during the pandemic.&nbsp; An analysis of counterfactually high COVID losses clearly shows that Forum members would have maintained sufficient capital to continue supporting the economy. &nbsp;&nbsp;

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Small businesses are vital to the growth and prosperity of our country. The Forum supported an extension of the Paycheck Protection Program, which provides forgivable loans to small businesses, so that all small businesses would have access to the support in 2021. 

In addition, we endorse policies that ensure the largest banks can best support the economy and market functioning during these difficult times.  The Forum in particular has backed policies that incentivize liquidity in markets and prevent unintended consequences to consumers and small businesses. 


Economic Support

Large Bank Resiliency During an Economic Crisis - the COVID Stress Test  

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State Street Corporation

Ron is chairman and chief executive officer of State Street Corporation. He is also a member of State Street Corporation’s Board of Directors. Ron was previously president and chief operating officer of State Street Corporation, and before that president and chief executive officer of State Street Global Advisors, the investment management arm of State Street Corporation. He joined State Street in 2015. Prior to State Street, Ron was president of Asset Management &amp; Corporate Services for Fidelity Investments, responsible for all Fidelity asset management organizations and Fidelity’s corporate functions and enterprise technology. He served at Fidelity from 2010 to 2014. Prior to joining Fidelity, Ron served as president and chief executive officer of BNY Mellon Asset Management in Boston, a position to which he was named in 2007. During this time, he also served as vice chairman of Bank of New York Mellon Corporation and was a member of its Executive Committee. Additionally, Ron oversaw all of Bank of New York Mellon’s activities in Asia. Prior to the 2007 merger of Bank of New York and Mellon, he was vice chairman of Mellon Financial Corporation and president and chief executive officer of Mellon Asset Management. He served at Mellon and Bank of New York Mellon from 1997 to 2010. Prior to Mellon, Ron was with McKinsey &amp; Company, Inc., from 1986 to 1997 and was elected a partner in 1992. He founded the Investment Management practice worldwide and was co-founder and co-leader of the firm’s North American Personal Financial Services practice. Additionally, he was a member of the Worldwide Property &amp; Casualty Insurance practice. During his tenure with McKinsey, Ron served in the firm’s Boston, New York, and Stockholm offices. Ron received his Bachelor of Arts degree in political science from Syracuse University in 1980 and his Master of Business Administration from Harvard Business School in 1986. Ron serves on the boards of Unum Corp. and Rhode Island Commerce Corporation. He also serves on the boards of Beth Israel Lahey Health, The Boston Foundation, IYRS School of Technology and Trades, Syracuse University and WBUR. Ron’s philanthropic and civic interests include corporate governance, retirement/healthcare policy and funding, education, and climate. He has led several initiatives on gender equality. Ron is a frequent speaker and writer, and an avid offshore sailboat racer.

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Ronald O'Hanley

State Street Corporation Chairman And Chief Executive Officer, Forum Chair

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Citigroup

Jane Fraser is the Chief Executive Officer of Citi, the world's most global bank, serving millions of consumers, businesses and institutions across 160 countries and jurisdictions. She is the first female CEO in the firm’s history. Jane has deep experience across Citi’s consumer and institutional businesses and, in many ways, she helped shape Citi into the company it is today. Before becoming CEO in February 2021, she was President of Citi and CEO of the Global Consumer Bank, responsible for all of Citi’s Consumer businesses, including Retail Banking and Wealth Management, Credit Cards, Mortgage and Operations and Technology in 19 markets. Before that, she was the Chief Executive Officer of Citigroup Latin America from 2015 to 2019. From 2013 to 2015, she was the Chief Executive Officer of the U.S. Consumer and Commercial Banking and CitiMortgage. From 2009 to 2013, Jane served as the Chief Executive Officer of Citi's Global Private Bank. Prior, Jane was the Global Head of Strategy and Mergers & Acquisitions for Citi from 2007 to 2009. She joined Citi in 2004 in the Corporate and Investment Banking division.
Before joining Citi, Jane was a Partner at McKinsey & Company. She started her career at Goldman Sachs in the Mergers & Acquisitions department in London and then worked for Asesores Bursátiles in Madrid, Spain. Jane serves as a Board Member for the Business Roundtable and the Council on Foreign Relations. She is Vice Chair for the Partnership for New York City and a member of Harvard Business School’s Board of Dean’s Advisors, the Stanford Global Advisory Board and the Economic Club of New York. Jane has an M.B.A. from Harvard Business School and an M.A. in economics from Cambridge University. She is married with two children.

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Jane Fraser

Citigroup Chief Executive Officer, Forum Vice Chair

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Bank Of America

Brian Moynihan leads a team of more than 200,000 employees dedicated to making financial lives better for people, companies of every size, and institutional investors across the United States and around the world.

Bank of America is recognized as a top employer by Working Mother magazine and Military Times. The company is also listed on Fortune magazine’s list of the Best Workplaces for Diversity and the Best Workplaces for Parents. It was also named one of the Best Places to Work for Disability Inclusion by the U.S. Business Leadership Network and the American Association of People with Disabilities. In 2018, Euromoney recognized Bank of America as the World’s Best Bank and the World’s Best Bank for Diversity and Inclusion, as part of their annual Global Awards for Excellence. Bank of America was also named the 2019 Catalyst Award winner, honored for supporting the continued development, empowerment and advancement of women in the company and around the world.

Moynihan participates in several organizations that focus on economic and market trends, including the World Economic Forum International Business Council, the Financial Services Forum, the Bank Policy Institute (chair), the Business Roundtable, and the American Heart Association CEO Roundtable (co-chair). He is also a member of the Federal Advisory Council of the Federal Reserve Board.

Moynihan leads the company’s Global Diversity and Inclusion Council and is a member of the museum council for the Smithsonian’s National Museum of African American History and Culture. Moynihan is also a member of the Brown University Corporation’s Board of Fellows and the Congressional Medal of Honor Foundation Board.

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Brian Moynihan

Bank Of America Chairman Of The Board And Chief Executive Officer

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BNY Mellon

Robin Vince is President and Chief Executive Officer of BNY Mellon and a member of its Board of Directors. Previously, he was Vice Chair of BNY Mellon and CEO of Global Market Infrastructure. In that role, he oversaw BNY Mellon’s Clearance and Collateral Management, Treasury Services, Markets and Execution Services and Pershing businesses.

Prior to joining BNY Mellon in October 2020, Robin was the Chief Risk Officer of Goldman Sachs and a member of the Management Committee. He joined Goldman Sachs in 1994 and held many leadership roles, including Treasurer, Head of Operations, Head of Global Money Markets, COO of the EMEA region and CEO of Goldman Sachs International Bank, among others. He served on several key subsidiary boards and governance committees. He was named managing director in 2002 and partner in 2006.

Robin is a member of National Geographic Society's Hubbard Council and serves on the Board of Advisors of The Hospital for Special Surgery.

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Robin Vince

BNY Mellon Chief Executive Officer

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The Goldman Sachs Group, Inc.

David Solomon is Chairman and Chief Executive Officer and a member of the Board of Directors of The Goldman Sachs Group, Inc.

Previously, he was President and Chief Operating Officer and prior to that, he served as Co-Head of the Investment Banking Division from 2006 to 2016. Before that, Mr. Solomon was Global Head of the Financing Group, which includes all capital markets and derivative products for the firm’s corporate clients. He joined Goldman Sachs as a Partner in 1999.

Mr. Solomon is a member of the Board of Trustees of Hamilton College and serves on the board of The Robin Hood Foundation.

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David Solomon

The Goldman Sachs Group, Inc. Chairman and Chief Executive Officer

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JPMorgan Chase & Co.

Jamie Dimon is Chairman of the Board and Chief Executive Officer of JPMorgan Chase & Co., a global financial services firm with assets of $2.5 trillion and operations worldwide. The firm is a leader in investment banking, financial services for consumers, small business, commercial banking, financial transaction processing and asset management.

Dimon became CEO on January 1, 2006 and one year later also became Chairman of the Board.  He was named President and Chief Operating Officer upon the company’s merger with Bank One Corporation on July 1, 2004. Dimon joined Bank One as Chairman and CEO in 2000.

Dimon began his career at American Express Company.  Next, he served as Chief Financial Officer and then President at Commercial Credit, which made numerous acquisitions and divestitures, including acquiring Primerica Corporation in 1987 and The Travelers Corporation in 1993. Dimon served as President and Chief Operating Officer of Travelers from 1990 through 1998 while concurrently serving as Chief Operating Officer of its Smith Barney Inc. subsidiary before becoming co-Chairman and Co-CEO of the combined brokerage following the 1997 merger of Smith Barney and Salomon Brothers.  In 1998, Dimon was named President of Citigroup Inc., the global financial services company formed by the combination of Travelers Group and Citicorp.

Dimon earned his bachelors degree from Tufts University and holds an MBA from Harvard Business School. He serves on the boards of directors of a number of non-profit institutions including the Clearing House and Harvard Business School. Additionally, he is the Chairman of the Business Roundtable and serves on the executive committee of the Business Council and the Partnership for New York City, and is a member of the Financial Services Forum, Financial Services Roundtable and Council on Foreign Relations.

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Jamie Dimon

JPMorgan Chase & Co. Chairman And Chief Executive Officer

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Morgan Stanley

Mr. Gorman is Chairman and CEO of Morgan Stanley.

Mr. Gorman became CEO in January 2010 and Chairman in January 2012. He joined the Firm in February 2006 and was named Co-President in December 2007.

Before joining Morgan Stanley, Mr. Gorman held a succession of executive positions at Merrill Lynch. Prior to this, he was a senior partner of McKinsey & Co. and began his career as an attorney in Melbourne, Australia.

Among his civic activities, Mr. Gorman serves as a Director of the Federal Reserve Bank of New York and the Council on Foreign Relations, and is a member of the Board of Overseers of the Columbia Business School, the Monetary Authority of Singapore International Advisory Panel, the Business Council, and the Board of the Institute of International Finance.

He formerly served as President of the Federal Advisory Council to the U.S. Federal Reserve Board, Co-Chairman of the Partnership for New York City, Chairman of the Board of the Securities Industry and Financial Markets Association and Co-Chairman of the Business Committee of the Metropolitan Museum of Art.

Mr. Gorman, who was born in Australia, earned a B.A. and Law degree from the University of Melbourne and an M.B.A. from Columbia University.

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James Gorman

Morgan Stanley Chairman And Chief Executive Officer

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Wells Fargo & Company

Charles W. Scharf is chief executive officer and president, and a member of the Board of Directors of Wells Fargo & Company.

A financial services veteran with 24 years of experience in leadership roles in the banking and payments industries, Charlie served as chief executive officer of Bank of New York Mellon from July 2017 to October 2019 and the chairman of its board from January 2018 to October 2018. He also was chief executive officer and a director of Visa Inc. from October 2012 to December 2016.

During his tenure at Bank of New York Mellon, Charlie demonstrated a strong track record in initiating and leading change, driving results, strengthening operational risk and compliance, and innovating amid a rapidly evolving digital landscape.

As the CEO of Visa, Charlie transformed the firm into a technology-driven digital commerce company by partnering with the world’s leading technology companies to drive new payment experiences and introduce new technologies to improve payment system security.

Previously, he was a managing director of One Equity Partners at JPMorgan Chase & Co. and chief executive officer of Retail Financial Services at JPMorgan Chase. He also was chief executive officer of the retail division of Bank One Corp., chief financial officer of Bank One Corp., chief financial officer of the Global Corporate and Investment Bank division of Citigroup, and chief financial officer of Salomon Smith Barney and its predecessor company.

Charlie earned a Bachelor of Arts degree from Johns Hopkins University and an MBA from New York University.

He is a director of Microsoft Corporation, serves on the board of trustees of Johns Hopkins University, is a member of The Business Council, and is chairman of the New York City Ballet. He lives in New York City.

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