Putting the Capital Requirements Debate to Bed
Also: Basel Committee Chair reflects on banking turmoil, and responses to the Biden Administration's position on National Bank Act preemption
This week is the Eurofi Financial Forum 2023 in Santiago de Compostela. Among other notable speakers, today’s agenda featured remarks from Andrea Enria, Chair of the European Central Bank’s Supervisory Board. The ECB on its Banking Supervision home page summarizes the speech as follows.
We need to put the debate on capital requirements to bed and move on, says Supervisory Board Chair Andrea Enria. Instead, we should focus on making our supervision as effective as possible and ensuring that banks address any shortcomings we identify.
Or, in Enria’s own words from the conclusion of his remarks:
So let’s move on from the debate on the calibration of capital requirements. Let’s implement the international standards we have all agreed on. And let’s focus on making sure that banks take the right corrective actions to address the shortcomings that their supervisors identify. It is in banks’ own interest to engage with us in in this endeavour and make sure that, the next time market confidence dwindles, no weak links can be identified.
I recommend reading the full speech, which is pretty thoughtful.
My focus here today, however, is on an interesting contribution to the debate on whether EU or US banks have it worse under their respective current implementations of the Basel rules.
Before ushering the capital requirements debate off to bed, Enria says:
[T]he industry has more recently turned its focus to international comparisons, making the argument that capital requirements are more demanding in the EU than in other jurisdictions, in particular the United States. They argue that the excessive conservatism of European regulators and supervisors makes the European banking industry less competitive on the global stage. The implication is that public authorities should look at capital requirements as a lever of international competitiveness to support their banks in the face of competition from banks in other regions.
Of course, while Enria’s speech (for understandable reasons) does not get into this, the industry in the United States makes the opposite claim. For instance, look at the testimony submitted to Congress today by the Financial Services Forum, a trade group that represents the U.S. GSIBs.
The core Basel III reforms were approved in 2013 and serve as the primary international capital standard implemented in the U.S. and other nations. The U.S., however, has chosen to implement capital requirements for its largest banks in a way that significantly exceeds the international standard. The largest U.S. banks therefore meet stricter capital requirements and maintain more equity capital on their balance sheets than their international peers, particularly those in the European Union.
Who is right? For various reasons Enria explains, it is hard to say. As he notes, the analysis ultimately requires “imagining a counterfactual scenario and making quite a few assumptions.” Therefore, one should not “make too much of the precise results.”
All those caveats aside, Enria goes to on to say that if you conduct an analysis that involves “assigning the European banks to the size buckets adopted in US legislation, applying the US rules to them and mapping them into a ‘stress capital buffer’ that is proportional to their risk profile, so as to include the Pillar 2 dimension in the analysis,” then you find that:1
Relative to their actual requirements today, we find the average requirement for European banking union significant institutions as a whole would be somewhat higher under the US rules.
The requirements would be significantly higher for the European G-SIBs, while they would be lower for most medium size and smaller European banks in the sample.
I realize that focusing on this section of Enria’s speech sort of goes against the spirit of the full remarks. As he says:
The focus on the comparison between EU and US requirements – and the intensity of the clash between banks and regulators on how capital requirements are calibrated – also reflects a bias. A bias that capital is the be-all and end-all of prudential supervision.
Still, because one suspects that, despite Enria’s best efforts, the debate on capital requirements is not going to be put to bed just yet, I thought the remarks quoted above were worth highlighting here.
In other capital-related news from today:
The House Financial Services Committee had its first hearing on the capital rules since returning from recess. In my unprofessional opinion there were not a ton of fireworks or much news coming out of the hearing, although I expect banks will chalk up as a modest win the fact that more than one member on the Democratic side of the aisle adopted a line of questioning that was something like, “You know I support strong capital standards, BUT….”
Davis Polk is out with a comprehensive set of slides breaking down the U.S. banking regulators’ Basel endgame proposal.
BCBS Chair Reflects on 2023 Banking Turmoil
Later in the day at the same Eurofi event, Pablo Hernández de Cos, Chair of the Basel Committee on Banking Supervision and Governor of the Bank of Spain, delivered keynote remarks.
Like Enria’s speech earlier in the day, it is a speech worth reading full, including for its decision to focus the mind by retelling this historical anecdote:
In 1800, a French chemist by the name of Éleuthère Irénée du Pont set up a gunpowder factory in Delaware. He quickly realised that gunpowder factories have an undesirable property: they tend to explode frequently. In response, du Pont took two initiatives. First, he required that the director (himself) live inside the factory with his family, putting his life on the line – what you could view as "skin in the game". Second, he established a rule that every new piece of machinery had to be operated for the first time by the factory's senior management. If the machine blew up, the manager would suffer the consequences. Needless to say, the safety of the plant increased overnight.
I don't think I need to draw out explicitly the comparisons with today's banking system. But it is clear that the turmoil raises some fundamental questions about the current banking system.
Later on, Hernández de Cos commented on four regulatory issues that he believes “would benefit from further analysis.” My abbreviated summary:
Liquidity.
What should be the objective of the LCR and NSFR? The LCR requires banks to be able to survive 30 days of stressed outflows, but should “we still expect banks to be able to survive a liquidity stress for 30 days without some sort of public intervention/resolution/private sector solution?” “Should the LCR be more focused on buying enough time for authorities to address a liquidity stress?”
Banks continue to be “reluctant or unable” to fully use the stock of liquid assets that the LCR and NSFR require them to hold - why is that?
Interest Rate Risk. Is the current approach, which is based on supervisory review (Pillar 2) and disclosure (Pillar 3) still appropriate, or “is there a need to move towards a Pillar 1 capital framework for IRRBB to promote greater international consistency and comparability?”
Definition of Regulatory Capital.
In addition to the much-discussed issue of unrealized losses, “the large-scale and ad hoc fire sales by some troubled banks to meet large-scale and simultaneous deposit withdrawals may also require reflection on how best to reflect the risks from second-round fire sales.”
Investors and markets failed to “fully internalise” the various ways losses on AT1 capital instruments could be triggered, “even though the Basel Framework contains explicit language on those trigger events and despite contractual documentation clearly highlighting the corresponding risk factors of such instruments.”2
Also, “the fact that a distressed bank continued to make expensive replacement issuances and to pay substantial amounts of discretionary interest on these instruments (alongside dividend payments for common shares), despite reporting losses over several consecutive quarters, raises questions about the ability of [AT1 capital] instruments to absorb losses on a going-concern basis.”
Application of the Basel Framework.
The Basel Framework “intentionally” does not define what it means to be an internationally active bank, but “recent events have shown that the failure of a bank can have systemic implications through multiple channels, including first- and second-round propagation effects.”
“Member jurisdictions are wholly responsible for deciding on whether and how to apply and design proportionate frameworks, and the recent turmoil highlighted how the distress of banks subject to domestic proportionality regimes could have cross-border financial stability effects.”
“The turmoil also highlighted how the design of proportionality frameworks can impede effective supervision by reducing standards, increasing complexity and promoting a less assertive supervisory approach.”3
National Bank and Plaintiffs Respond to Biden Administration’s Position on National Bank Act Preemption
As discussed in a post a couple weeks ago, the Biden Administration, through the Solicitor General, has advised the Supreme Court that it should not, at this stage, get involved in the fight over whether state laws requiring the payment of interest on certain mortgage escrow accounts may be applied to national banks.
Today, responses were filed to the Solicitor General’s brief. As context for those responses, a short recap of the events so far:
At least 13 states have laws requiring banks to pay on interest on certain mortgage escrow accounts.
Consumers in some of these states have sued national banks for not paying them the interest they claim they are owed under these interest-on-escrow laws.
National banks say that those laws are preempted by the National Bank Act and therefore cannot be applied to them.
The Office of the Comptroller of the Currency, which regulates national banks, has filed legal briefs agreeing with the national banks. It did so under the Trump Administration and under the current Acting Comptroller, who was installed in the role by the Biden Administration.4
The Ninth Circuit Court of Appeals in a decision in 2018 sided with the consumer plaintiffs, saying that the National Bank Act does not preempt state interest-on-escrow laws.
The Second Circuit Court of Appeals in a decision in 2021 sided with the national banks, saying that state interest-on-escrow laws are preempted.
The Biden Administration last week said both the Ninth Circuit decision and the Second Circuit decision are wrong, although it reserved the harsher criticism for the Second Circuit decision (and the 2021 position of its own appointed Acting Comptroller of the Currency).
Despite believing both decisions below are wrong, the Biden Administration believes the more prudent move at this stage would be for the Supreme Court not to hear the appeals of either case, but instead to allow the issue to further “percolate” in the lower courts.
Unsurprisingly, neither Flagstar Bank, N.A. (which lost in the Ninth Circuit) nor the consumer plaintiffs (who lost in the Second Circuit) are fully on board with the government’s position. Both also agree that the Biden Administration’s rejection of the position previously taken by its own OCC is something that argues in favor of, rather than against, the Supreme Court deciding to hear the case.
For example, this is from the first page of Flagstar’s response.
The government acknowledges that this petition has all the hallmarks of certworthiness: a conflict in the courts of appeals on an important and recurring federal question, an incorrect decision below, and no obstacle to the Court’s review. […]
Yet instead of urging this Court to resolve the conflict and correct the error below, the government asks the Court to deny certiorari, leave the conflict unresolved and the incorrect decision below in place, and await further percolation. Specifically, the Department of Justice unveils its own brand-new theory of National Bank Act preemption and urges the Court to wait for some lower court to adopt it.
The problem is, there is no reason to think that will happen, certainly not anytime soon. For one, the government’s brief explicitly (and strikingly) rejects the longstanding view of the government’s primary banking regulator, the Office of the Comptroller of the Currency.
And from the first page of the response of the consumer plaintiffs’:
The government’s brief agrees with much of what our petition says: It agrees that the Second Circuit’s decision is incorrect, that there is a split, and that National Bank Act preemption under Dodd-Frank is an important issue. Yet the government asks the Court to deny certiorari to allow for percolation because the Solicitor General has now disavowed the contrary position taken by the Office of the Comptroller of the Currency in its brief below. […]
The government’s brief represents a sea change in the federal government’s position on NBA preemption […] Now it is clear that the OCC’s brief does not represent the views of the United States—and that the federal government’s position is in fact contrary to the OCC’s.
What Does the OCC Make of All This?
The Flagstar response also observes that the OCC “conspicuously does not sign the government’s brief—only DOJ does.” One might think that makes sense — after all, this brief was submitted by the Solicitor General, not the OCC. But Flagstar’s response contends this is actually a deviation from past practice:
Little wonder the OCC has chosen not to sign the government’s brief in this case—whereas it previously has co-signed the Solicitor General’s briefs addressing the NBA, including at the cert. stage. [FN]
[FN] See, e.g., U.S. Br., Midland Funding, LLC v. Madden, No. 15- 610 (2016); U.S. Br., Cuomo v. The Clearing House Ass’n, No. 08- 453 (2009); U.S. Br., Watters, supra (2006).
Does this choice (if it was indeed a choice) actually reflect a disagreement at the OCC with the Biden Administration’s position? It is hard to say. Since the Biden Administration filed its brief in late August, no one at the agency has had anything to offer publicly on a question which in 2021 Acting Comptroller Hsu’s OCC called a matter of “foundational consequence” to the national banking system.
Thanks for reading! Comments on this post are welcome at bankregblog@gmail.com
What drives this? Enria says:
If we set aside the US gold-plating of international standards in the area of G-SIB buffers and leverage ratio requirements, this result stems from the way in which risk weighted assets are calculated. Here, EU legislation has several downward adjustments relative to international standards, including the non-compliant application of the Basel I floor, which plays a key role in making the EU framework less demanding. Meanwhile, the US rules related to the Collins amendment impose a strict floor based on the standardised approach for credit risk.
On this topic, interesting (although perhaps ultimately beside the point) reading this week was a BIS Financial Stability Institute paper from Rodrigo Coelho, Jatin Taneja and Rastko Vrbaski entitled Upside down: when AT1 instruments absorb losses before equity.
There is no citation to it here, but notably this tracks verbatim the claim made on the first page of the letter from Vice Chair for Supervision Michael Barr accompanying his report on SVB.
The Board’s tailoring approach in response to the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA) and a shift in the stance of supervisory policy impeded effective supervision by reducing standards, increasing complexity, and promoting a less assertive supervisory approach.
Specifically, “The U.S. Department of the Treasury today announced that Michael J. Hsu will become Acting Comptroller of the Currency on May 10, 2021, pursuant to 12 USC 4 as designated by Secretary of the Treasury Janet Yellen.”