Perspectives on U.S. Monetary Policy and Bank Capital Reform – speech by Governor Michelle W. Bowman at Policy Exchange, London, England

Bank Capital Reform
I will now briefly touch on bank capital reforms, which are particularly important when it comes to our global and interconnected banking and financial systems. The U.S. has lagged its EU and U.K. counterparts in fully implementing the Basel III capital standards. In July 2023, the U.S. federal banking agencies issued a public consultation on implementing what we call the Basel III “endgame” capital reforms.⁷

The U.S. proposal was notable for a number of reasons, but I would highlight two in particular. First, the U.S. proposal would significantly expand the scope of application and calibration of these capital requirements. And, second, this proposal went beyond the Basel framework in several areas, undermining the goal of increasing consistency in capital standards across jurisdictions and potentially creating competitive concerns. The response to the U.S. capital proposal was overwhelmingly negative from a broad range of commenters.

Calibration and scope
A key consideration in evaluating reform efforts is whether the benefits of a change outweigh the costs, both for the financial institutions subject to these reforms and for the broader economy. The benefits of reform, like Basel III, are clear—on a basic level, higher capital can make the banking system safer. At a minimum, this increased safety comes at a cost; in its more extreme forms, it can actually increase financial stability risks.

The Basel III proposal in the U.S. is complex and, if it were to apply today as proposed, could have very significant, detrimental impacts. Federal Reserve staff estimated that the proposed changes would result in an aggregate 20 percent increase in total risk-weighted assets across bank holding companies subject to the rule, with some commenters projecting much greater effects.⁸ And, instead of these standards applying only to large, internationally active banks, the U.S. proposal would “push down” these standards to a much broader range of domestic institutions.

A change of this significance could impact U.S. market liquidity and lending as well as force firms that lack sufficient economies of scale to stop providing certain products and services. Capital increases of this scale could reduce the cost and availability of credit, particularly for certain types of loans, and could disproportionately harm underserved markets, businesses, and communities. In my view, the proposal insufficiently considered these direct costs. These are costs that would ultimately be imposed on bank customers.

Of course, the evaluation of reforms should not end at their direct costs. Many of the costs are indirect or unintended and may be substantial, creating further concerns, including risks to financial stability. These reforms could create an exodus of activities and products from the banking system due to the indirect costs and unintended consequences.

Over time, activity tends to migrate to where it can be conducted efficiently and at the least cost. Capital requirements can play a significant role in determining where and by whom an activity is conducted. Banks are often best positioned to provide financial products and services due to their expertise and experience as well as their requirement to operate safely and soundly. When the over-calibration of regulatory costs becomes too significant, activities often migrate out of banks and into the nonbank financial system, potentially leading to greater systemic risks.

Up until this point, I have focused primarily on the “cost” side of the analysis, and I think it is fair to characterize the direct and indirect costs of the proposed Basel III rule as substantial. But we must also measure these costs against the benefits such capital increases could provide.

As a starting point for this analysis, we must evaluate the current state of the banking system. In the U.S., given the increase in capital following the 2008 financial crisis, I do not see undercapitalization of large banks as a current vulnerability. While some have argued that large capital increases should be part of the regulatory response following the 2023 U.S. banking stress, I think this argument lacks a solid foundation.

First, as we know, the Basel reforms were being developed long before last year’s banking stress. The U.S. proposal included regulatory changes that had previously been considered and rejected as part of the Basel III implementation—specifically, a significant accounting change regarding the treatment of unrealized losses on securities portfolios.⁹ While revisiting this one element of Basel III has been used to try tying the rulemaking initiative to the regulatory response to the bank failures last spring, the majority of the proposed changes are unrelated to last spring’s banking stress.

Second, linking this rulemaking to the banking stress implies that the causes of individual bank failures in the spring of 2023 were in some way a signal of broader banking system weakness, which could best be addressed by significant capital increases.

This argument seems to rely on the philosophy that more capital makes stronger banks, regardless of costs and tradeoffs, or possible more efficient approaches. Linking the proposed capital increases to the bank failures in the spring of 2023 should not be used as a pretext to avoid the challenges of identifying and evaluating the tradeoffs involved with setting capital requirements, nor should it excuse regulators from taking a hard look at the root causes of the bank failures with the goal of identifying more targeted solutions than across-the-board capital increases.

In the case of Silicon Valley Bank (SVB), both bank management and supervisors failed to appreciate, appropriately identify, and mitigate the known, significant, and idiosyncratic risks of a business model that relied on a highly concentrated, uninsured base of depositors. They also overlooked the buildup of interest rate risk without appropriate risk management. These management failures arguably support an honest and critical look at how supervision was conducted in the lead-up to the firm’s failure. And it would then be appropriate to propose changes to remediate those deficiencies. But the failures did not suggest either that “capital” was the major problem contributing to SVB’s failure or that undercapitalization was a broader problem in the banking system.

Basel III capital reforms and international consistency
Before discussing the path ahead, I will also address one of the factors that should be a focus for regulatory reforms that may resonate in this forum: the issue of international comparability and competitive disadvantages. One of the primary purposes of the Basel capital standards is to promote minimum standards across jurisdictions that not only improve competitive equity in banking markets, but also result in making the financial system safer.

While I have expressed some skepticism of the U.S. Basel III proposal, I see value in engaging in ongoing discussions about international coordination through multilateral organizations like the Basel Committee on Banking Supervision. Some degree of consistency in international banking and financial markets can be helpful in fostering a cross-border level playing field for internationally active banking organizations while establishing minimum standards that can help mitigate global financial stability risks.

In internationally active banking and financial markets, there are often “choices” about where activity can be conducted. Financial products and services are offered around the world in different markets, and there is often some degree of flexibility as to how a customer can access a product or service. This competitive “choice” aspect of international banking and financial markets can itself create downward pressure on regulatory standards and create opportunities for forum shopping.

In the absence of some degree of international coordination, there is a risk of creating a regulatory “race to the bottom,” as regulators compete to grow their banking and financial systems by lowering regulatory and supervisory standards below levels that are appropriate based on risk. But this desire for greater international consistency can be equally frustrated when U.S. regulators excessively calibrate requirements. As I previously noted, the U.S. proposal was calibrated at a level well in excess of other international jurisdictions as well as without sufficient analytical support and evidence that the proposed increases were proportionate to risk.

This is not only a problem for international competitive equity, but also a concern for global financial stability. Significant banking activities occur in the international and cross-border context, and we know that financial stability risks can spread throughout global financial markets. The U.S. Basel proposal reflects elements of the agreed-upon standards, but it far exceeds them. Adjusting the calibration could have the important secondary benefit of enhancing this international consistency.

The path forward
Notwithstanding what has brought us to this point, I do see a path forward to implement Basel III, one that addresses not only the overall calibration as well as international consistency and comparability, but also makes more granular changes that will improve the effectiveness and efficiency of the rule.

In October 2023, the Federal Reserve launched a data collection to gather information from the banks affected by the U.S. proposal. I am hopeful that this data will allow regulators to better understand the impact of the proposal and to identify areas for revision. Any next step in this rulemaking process will require broad and material changes. It should also be accompanied by a data-driven analysis of the proposal and informed by the significant public input received during the rulemaking process. This should assist policymakers in creating a path to improve the rulemaking. My hope is that policymakers pay closer attention to the balance of costs and benefits and consider the direct and indirect consequences of the capital reform.

I have previously identified a number of specific areas and procedural steps that would be necessary to address in any future efforts to revise this proposal. Some of these issues include

• addressing redundancy in the capital framework (for example, between the new market risk and operational risk requirements, and the stress capital buffer)
• recalibrating the market risk rule specifically, where some of the biggest outlier increases in risk-weighted assets would appear (for example, these revisions alone will increase risk-weighted assets from $430 billion to $760 billion for Category I and II firms, and from $130 billion to $220 billion for Category III and IV firms)
• adopting a more reasonable treatment for non-interest and fee-based income through the operational risk requirements, which could deter banks from diversifying revenue streams, even though such diversification can enhance an institution’s stability and resilience
• reviewing the impact of capital requirements, including leverage ratio requirements, on U.S. Treasury market intermediation and liquidity
• incorporating tailoring in the applicability of Basel III capital reforms, specifically looking at whether each element of the Basel III capital proposal is appropriate for non-G-SIB firms that are not internationally active
• re-proposing the Basel III standards to address the broad and material reforms that I believe should be included in any final rule, including granular changes to address the specific issues raised by commenters, as appropriate.¹⁰

While these steps would be a reasonable starting place, they are not a replacement for a data-driven analysis and a careful review of the comments submitted. This would result in a better proposal that includes changes to address not only these concerns, but also many other concerns raised by the public.

The full speech can be read here.

Source: The Federal Reserve