The writer is the former chair of the FDIC
Financial regulators in the US propose to weaken capital requirements for the nation’s eight largest banks, aka “global systemically important banks” or “G-SIBs”. This break will supposedly entice the G-SIBs to use freed-up capital to buy more US Treasuries, thus lowering government’s interest costs, but even some of the big banks have said that is unlikely. It will, however, significantly weaken the G-SIBs’ capacity to lend to Main Street. It will also worsen the competitive advantages they enjoy over community and regional banks.
At issue is the enhanced supplementary leverage ratio (eSLR), a simple binding constraint on G-SIBs’ debt to equity ratios and a central feature of post-2008 crisis reforms. Smaller banks are also subject to leverage limitations, but regulators sensibly concluded the big guys needed enhanced limits. Requiring higher levels of equity capital also helps offset the lower borrowing costs that G-SIBs unfairly enjoy from their perceived “too big to fail” status. The proposed reductions in the eSLR would remove much of this benefit for smaller banks.
The reductions are particularly significant at the G-SIBs’ subsidiaries that hold deposits insured with Federal Deposit Insurance Corporation, with reductions of 27 per cent, or $210bn, in the amount of equity capital they need to hold. Perversely, slashing capital requirements at G-SIBS’ insured banks will have little impact on their capacity to support the Treasuries market because they carry out that function in their broker-dealers.
Most of these broker-dealers are limited by a different set of “risk-based” capital rules. Regulators theorise the G-SIBs can reallocate capital from their FDIC-insured banks to their broker-dealers to support dealer operations in Treasuries. But it seems just as likely they would invest it in their broker-dealers’ other riskier, higher-yielding operations.
This reallocation would come at Main Street’s expense. The G-SIBs primarily do their lending to households and businesses out of their insured banks. That $210bn of capital supports about $2.7tn in bank loans. If released, it would no longer support lending nor would be available to absorb losses in a downturn, impairing the ability to maintain credit flows when it is most needed.
Such a drastic capital reduction would also increase the risk that a G-SIB insured bank could become insolvent, imperilling the deposit insurance system. Regulators argue that if a G-SIB’s insured bank runs into trouble, the holding company would ride to the rescue under a Federal Reserve Board doctrine requiring them to be a “source of strength” for their insured banks. But during the 2008 financial crisis, the opposite happened, with the FDIC repeatedly accommodating Fed requests to send capital from insured banks to bail out broker-dealers.
In future periods of stress, G-SIBs’ riskier broker-dealers are more likely to be the ones in trouble. They will be in no position to reallocate capital back to the insured bank. The FDIC does have untested authority to seize a holding company and move capital downstream to the insured bank to prevent its failure. However, its success depends on the co-operation of the Fed and the strength of the holding company. If the bank does fail, the losses would have to be absorbed by all banks, large and small, which pay premiums to fund FDIC’s reserves, as well US taxpayers who stand behind the agency’s guarantee.
Of course, the capital will be unavailable to help either the broker-dealer or the insured bank if the G-SIBs distribute it to shareholders. The regulators say other “risk-based” rules, which vary depending on the perceived riskiness of a bank’s assets, will keep the capital trapped in the holding company. But G-SIBs can easily reduce those requirements by changing their asset mix. Regulators are also expected to further weaken risk-based requirements.
The regulator’s job is to ensure the safety and stability of the financial system, not help the government fund its deficits. It’s not even clear that the eSLR affects Treasuries dealer functions. A study published by the Fed in 2023 concluded it did not. If the concern is G-SIBs’ ability to support the Treasuries market in a crisis, regulators have the authority to provide temporary relief.
If regulators want to deregulate, I humbly suggest they instead focus on community banks. While megabanks have thrived since the 2008 crisis, this sector has shrunk over that time from 7,000 institutions to just 4,000 today. They struggle with steep compliance costs, outdated reporting requirements and higher costs of capital given their “small enough to fail” status. They are a vital source of credit for small businesses and rural communities. Help them.
A globally recognized authority on financial regulation and economic policy, Sheila Bair led the FDIC through the 2008 financial crisis and has since continued to shape the future of finance through leadership roles in government, academia, and the private sector. Named to Time’s “Top 100” and Forbes’ “Most Powerful Women” lists, she is a trusted voice on stability, reform, and consumer protection in the global economy. To bring Sheila Bair’s insight and leadership to your next event, contact WWSG.
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