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Bank capital was the focus of an important speech given by Michael Barr, the Federal Reserve’s vice-chair for bank supervision, on Monday. Although the speech did not break any news, it proposed regulatory and supervisory changes that could significantly impact banks’ profit profiles. Surprisingly, bank stocks did not react to the proposed changes. While the changes are not new, as they are based on the Basel III international framework, the speech shed light on the Fed’s regulatory philosophy. Barr believes that higher capital can solve all problems, but this notion is flawed.
The speech primarily advocated for changes in the assessment of banks’ risks and the corresponding capital requirements. Credit risks should be standardized, instead of allowing banks to use internal models. Quality standards should be imposed for trading risk, and risk should be measured at the product or trading desk level, rather than at the holding company level. Additionally, operational risk should be standardized as well. Barr proposes that these rules should apply to all banks with assets of $100 billion or more.
According to Barr, these changes, along with others, would require banks to hold an extra two percentage points of capital, which is a significant increase. For example, a bank with an equity capital ratio of 10% and a return on assets of 1.5% would experience a decrease in return on equity from 15% to 12.5%. This would have a considerable impact on profitability, and banks are not pleased with these changes. However, the banks were aware of these changes and the likelihood of them being implemented. Barr made sure to highlight the recent collapses of Silicon Valley Bank, First Republic Bank, and Signature Bank at the beginning of his speech. He argued that including losses on “available for sale” securities in bank capital could have potentially prevented the collapse of Silicon Valley Bank.
This argument is flawed as most of the security losses at Silicon Valley Bank were in its “held to maturity” portfolio, not its “available for sale” portfolio. Moreover, the proposed changes would not have provided enough capital for Silicon Valley Bank to withstand the depositor run it faced. Barr has yet to justify his proposals adequately. Additionally, it is unclear how changing the accounting treatment for “available for sale” securities or increasing capital requirements would incentivize banks to manage interest rate risks better. Barr’s claims that banks required to reflect unrealized losses on these securities in regulatory capital managed interest rate risks more carefully lack supporting evidence. Large banks like Bank of America, which already had more rigorous treatment of “available for sale” securities, still suffered significant losses.
According to Brian Foran of Autonomous Research, Barr’s proposals fail to address the core issues of the recent mini-crisis, such as uninsured deposits, held-to-maturity securities, and interest rate risks. Barr promises to address these issues later, but it remains to be seen if these promises will result in effective solutions.
This leads to the main philosophical principle underlying Barr’s speech, which is that higher capital can solve all problems in bank regulation and supervision. Capital allows banks to absorb losses and continue operating, regardless of the source of the loss. Higher capital levels also incentivize banks’ managers and shareholders to manage risks prudently. However, this notion is contradicted by the collapses of Silicon Valley Bank and First Republic, which had adequate capital but still failed due to imprudent management by their managers and shareholders.
Furthermore, it is not evident that the US banking system as a whole lacks capital. During the recent mini-banking crisis, the capitalization of the big banks, known as GSIBs, was never a concern. There were no doubts about the overall capital adequacy of the system. Barr and his colleagues need to provide more explanations for their proposals.
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