Treasury Announces Bank Capitalization Wish-List

Treasury has announced:

the core principles that should guide reform of the international regulatory capital and liquidity framework to better protect the safety and soundness of individual banking firms and the stability of the global financial system and economy.

There are eight of these core principles given a brief explanation in the detailed announcement:

Core Principle #1: Capital requirements should be designed to protect the stability of the financial system (as well as the solvency of individual banking firms).

Among other things, a macro-prudential approach to regulation means: (i) reducing the extent to which the capital and accounting frameworks permit risk to accumulate in boom times, exacerbating the volatility of credit cycles; (ii) incorporating features that encourage or force banking firms to build larger capital cushions in good times; (iii) raising capital requirements for bank and non-bank financial firms that pose a threat to financial stability because of their combination of size, leverage, interconnectedness, and liquidity risk (Tier 1 FHCs) and for systemically risky exposure types; and (iv) improving the ability of banking firms to withstand firm-specific and system-wide liquidity shocks that can set off deleveraging spirals.

The document refers to Tier 1 FHCs quite often, raising the disquieting potential that this status will officially bestowed, which is the wrong thing to do. Instead, it would be far superior to (i) assign a progressive surcharge onto Risk-Weighted Assets as the firm gets larger; e.g., if RWA=$250-billion, no surcharge; 10% surcharge on the next $50-billion; 20% on the next $50-billion; and so on. A dual-track regime (one for Tier 1 FHCs, another for also-rans) is just going to create problems; and (ii) eliminate the favoured status of bank paper in the risk-weighting, so that banks in general hold less of each other’s paper.

Core Principle #2: Capital requirements for all banking firms should be higher, and capital requirements for Tier 1 FHCs should be higher than capital requirements for other banking firms.

See above

Core Principle #3: The regulatory capital framework should put greater emphasis on higher quality forms of capital.

For these reasons, during good economic conditions, common equity should constitute a large majority of a banking firm’s tier 1 capital, and tier 1 capital should constitute a large majority of a banking firm’s total regulatory capital. In addition, the inclusion in regulatory capital of deferred tax assets and non-equity hybrid and other innovative securities should be subject to strict, internationally consistent qualitative and quantitative limits.
We also consider it important that voting common equity represent a large majority of a banking firm’s tier 1 capital.

In other words, they don’t like the extent to which preferred shares and Innovative Tier 1 Capital have been used and they really dislike sub-debt.

Core Principle #4: Risk-based capital requirements should be a function of the relative risk of a banking firm’s exposures, and risk-based capital ratios should better reflect a banking firm’s current financial condition.

Among other things, we must reduce to the extent possible the vulnerabilities that may arise from excessive regulatory reliance on internal banking firm models or ratings from credit rating agencies to measure risk.
Risk weights should be a function of the asset-specific risk of the various exposure types, but they also should reflect the systemic importance of the various exposure types. From a macro-prudential perspective, exposure types that exhibit a high correlation with the economic cycle, or whose prevalence is likely to contribute disproportionately to financial instability in times of economic stress, should attract higher risk-based capital charges than other exposure types that have the same level of expected risk. One of the key examples of a systemically risky exposure type during the recent crisis was the structured finance credit protection purchased by many banking firms from AIG, the monoline insurance companies, and other thinly capitalized special purpose derivatives products companies.

I think that this is as close as Treasury will every get to admitting it goofed big-time on allowing uncollateralized leverage credit protection to offset cash positions.

Core Principle #5: The procyclicality of the regulatory capital and accounting regimes should be reduced and consideration should be given to introducing countercyclical elements into the regulatory capital regime.

The regulatory capital and accounting frameworks should be modified in several ways to reduce their procyclicality. First, the regulatory capital regime should require banking firms to hold a buffer over their minimum capital requirements during good economic times (to be available for drawing down in bad economic times).

There’s a possibility that good times and bad times might become something of a political football, isn’t there? We should not forget that one reason why the FDIC has to increase rates charged to banks right now is because Congress gave a long contribution holiday for political reasons.

I am gratified to see:

Finally, we should examine the merits of providing favorable regulatory capital treatment for, or requiring some banking firms (such as Tier 1 FHCs) to issue, appropriately designed contingent capital instruments – including (i) long-term debt instruments that convert to equity capital in stressed conditions; or (ii) fully secured insurance arrangements that pay out to banking firms in stressed conditions.

See my essay on insurers’ risk transformation.

Core Principle #6: Banking firms should be subject to a simple, non-risk-based leverage constraint.

To mitigate potential adverse effects from an overly simplistic leverage constraint, the constraint should at a minimum incorporate off-balance sheet items.

They couldn’t get the Europeans to agree to the leverage ratio last time, and now they’re MAD!

Core Principle #7: Banking firms should be subject to a conservative, explicit liquidity standard.

The liquidity regime should be independent from the regulatory capital regime. The liquidity regime should make both individual banking firms and the broader financial system more resilient by limiting the externalities that banking firms can create by taking on imprudent levels and forms of funding mismatch. Introducing strict but flexible liquidity regulations would reduce the chances of destabilizing runs by enhancing the ability of debtor banking firms to withstand withdrawals of short-term funding and by making creditor banking firms less likely to withdraw short-term funding from other firms.

Much of this would be addressed by eliminating the favourable risk-weighting applied to inter-bank holdings, as noted above.

Core Principle #8: Stricter capital requirements for the banking system should not result in the re-emergence of an under-regulated non-bank financial sector that poses a threat to financial stability.

Money market mutual funds will be subject to tighter regulation, including tighter regulation of their credit and liquidity risks.

Basically, they want to regulate everything that moves, which will have bad effects on the economy. They should spend more time properly regulating the boundary between banks and non-banks, so that shadow-bank collapses will not have a severe effect on the highly regulated core banking system.

10 Responses to “Treasury Announces Bank Capitalization Wish-List”

  1. […] announced a bank capitalization wish-list last week prior to the G-20 London […]

  2. […] Treasury’s proposals for capital reserves have been previously reported. […]

  3. […] good proxy for “non-financial” in my analysis). Assiduous Readers will remember that Treasury’s wish-list for bank regulation includes: many of the [Bank Holding Companies] that have been most active in volatile capital […]

  4. […] surcharge is infinitely preferable to flat prohibitions and Treasury’s special regime. The report repeatedly warns about “cliff effects” in the securitization market; such […]

  5. […] King’s remarks put him somewhat at odds with the US Treasury, which wants separation based on size, not function. […]

  6. […] my guess that this is happening under Treasury’s resolve to look at consolidated capital – but the intellectual dishonesty of OSFI is such that no acknowledgement is made of any external […]

  7. […] another 10% on top of that, and so on. Very few formal ideas have been proposed in this line; the US Treasury wish-list does not mention such an idea but endorses a special regime for those institutions deemed too big […]

  8. […] particular interest is her disagreement with one element of Treasury’s wish-list: Yes, regulators should try to assess systemic risk. But no, we should not try to define […]

  9. […] What happens if the rules for calculation of this ratio change? They’re supposed to change! Treasury and BIS are working feverishly to change them! Does Lloyds have to maintain a calculation of ratios […]

  10. […] Treasury Announces Bank Capitalization Wish-List […]

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