The leverage ratio, holistically
Also, anti-ESG Republicans signal a continued focus on "control" issues, and a look at some questions the SEC is asking banks
On Thursday FDIC Chair Gruenberg delivered remarks at the Peterson Institute for International Economics on the Basel III endgame. The speech was mostly as expected, including something close to an endorsement of applying some or all of the new rules to all firms with assets of $100 billion or more, as well as a pre-emptive response to potential criticisms of the new rules.
Toward the end, though, there was a section that may signal a different debate worth watching.
Finally, it has been suggested that since Basel III will raise risk-based capital requirements, leverage capital requirements should be lowered to offset the burden on the largest banks….
Leverage capital requirements and the risk-based capital framework are therefore mutually reinforcing, in that they each cover risk which the other is less able to capture. This ensures banks do not operate with excessive leverage and at the same time have sufficient incentives to keep risk-taking in check. That is why maintaining strong leverage capital requirements along with risk-based requirements will ensure the resiliency of the largest, most systemically important banks is not compromised.
Indeed, maintaining robust leverage requirements is important as we move forward with implementation of the revised Basel III risk-based standards. It was an essential post-crisis reform that must not be weakened.
One way to read this is a signaling that Chair Gruenberg is not on board with potential changes to the denominator of the leverage ratio to exclude central bank reserves or Treasuries. No surprise there. What I am more curious about is what this passage suggests about what Chair Gruenberg, and the U.S. banking regulators more generally, are thinking about a different potential change to leverage ratio requirements.
Basel III Leverage Ratio Requirements Generally
The Basel III framework agreed following the 2008 financial crisis includes a leverage capital requirement for banks. Unlike a risk-weighted capital requirement, in which the amount of capital that must be used to fund an asset varies with the riskiness of the asset, a leverage capital requirement is a simple ratio of Tier 1 capital to total assets (plus some other stuff1). The Basel III leverage ratio requirement is 3%.
In the United States the terminology gets a little complicated, as nearly all banks even before Basel III were subject to a simple leverage ratio requirement based on Tier 1 capital / total assets. So because the U.S. already had a leverage ratio requirement, the Basel III leverage ratio in the U.S. is referred to as the supplementary leverage ratio, or SLR. The SLR currently applies to the eight U.S. global systemically important banks (GSIBs), as well as a few other large firms with total assets of at least $250 billion.
Additional Buffer
Under the current U.S. implementation of the Basel III rules, a U.S. GSIB is required to maintain, in addition to its 3% SLR requirement, an additional buffer of 2%. This buffer is not a regulatory minimum, meaning that a banking organization can eat into it without running afoul of capital requirements, but doing so leads to restrictions on capital distributions and certain bonus payments. The practical effect of this has been that U.S. GIBs regard 5% as their SLR requirement. This has come to be known as the “enhanced” supplementary leverage ratio, or eSLR.
In addition to this buffer requirement that applies at the holding company level, the bank subsidiary of a U.S. GSIB must maintain an SLR of at least 6 percent to be considered well capitalized.
2018 Federal Reserve Board and OCC Proposal
In 2018, the Federal Reserve Board (with Governor Brainard voting against) and OCC proposed to make changes to the eSLR. Rather than having the buffer be a flat 2% for all firms, the agencies proposed that the buffer instead be set at one-half of a firm’s GSIB risk-based capital surcharge. The well capitalized SLR requirement for depository institution subsidiaries would have been similarly revised to no longer be 6% but to instead be 3% plus one-half of the holding company’s GSIB surcharge. The Board also proposed similar changes to its total loss absorbing capacity requirements.2
The Federal Reserve Board made the case that, if you took into account the full picture of capital requirements, including those imposed as a result of the Board’s supervisory stress test, overall capital requirements at the holding company level would be little changed by the new rule.
Taking into account supervisory stress testing and existing capital requirements, agency staff estimate that the proposed changes would reduce the required amount of tier 1 capital for the holding companies of these firms by approximately $400 million, or approximately 0.04 percent in aggregate tier 1 capital.
Those in opposition to the proposal, however, questioned whether this was the best lens through which to view things. These people argued that even assuming the Board was correct about the impact of the change at the holding company level, there would be a substantial reduction in SLR requirements at the subsidiary level. See, for example, this letter from the Systemic Risk Council.
[W]hile the effect of the Regulators’ proposal on bank holding companies might be modest, there would be a material reduction in equity requirements for operating bank subsidiaries. The differential impact on opcos and holdcos arises for two reasons. First, the stating points are different (6% and 5% respectively). Second, the Regulators currently apply two sets of equity requirements — the risk-based GSIB surcharges and the stress-testing requirements — only at the holdco level (i.e., not to individual banking subsidiaries).
Then-FDIC Chair Gruenberg made a similar comment at the time the rule was proposed, focusing on the effect the proposal would have at the bank level, even if overall holding company requirements would not change very much.
As stated in the NPR, “The amount of tier 1 capital required under the proposed eSLR standard across the lead IDI [insured depository institution] subsidiaries would be approximately $121 billion less than what is required under the current eSLR standard to be considered well-capitalized.” Given these reductions in capital requirements, the FDIC did not join the Federal Reserve and OCC in issuing the proposed rule.
On some level the FDIC’s refusal to support the proposal was academic, as no U.S. GSIBs have IDI subsidiaries supervised by the FDIC. So long as the Board and OCC finalized the rule, all eight U.S. GSIBs would have remained on equal footing. As it turned out though, the Board and OCC never finalized the rule.
Basel Again
Based only on what we have discussed so far, this probably looks like an unlikely source of drama in a forthcoming rule proposal. The outcome appears pretty well determined. A regulatory change was proposed in 2018 under Republican regulators and was opposed by regulators appointed by Democrats. The change was never finalized and now, with regulators appointed by Democrats back in charge (in some cases, literally the same regulator), you would expect it never will be.
But it is here I must confess I have been hiding the ball a little. In 2017, as part of the Basel III finalization, the Basel Committee also adopted a leverage buffer requirement for GSIBs. And look at how that leverage buffer requirement is calculated:
The leverage ratio buffer will be set at 50% of a G-SIB’s higher-loss absorbency risk-weighted requirements. For example, a G-SIB subject to a 2% higher-loss absorbency requirement would be subject to a 1% leverage ratio buffer requirement.
This is why the Board and OCC claimed in 2018, not without justification, that their “changes also correspond to recent changes proposed by the Basel Committee on Banking Supervision.” (This is true at the holding company level. The Basel standard does not address what IDI SLR requirements should be because not all banks are organized like they are in the U.S. with a holding company/subsidiary structure.)
What Now?
I have no idea what the U.S. regulators are going to do, but this Basel leverage buffer standard complicates things at least a little and means the analysis cannot completely proceed on the assumption that every single part of the 2018 proposal is off the table.
One path forward could be to adopt the Basel approach for purposes of the eSLR buffer at the holding company level, while leaving the well capitalized requirement of 6% at the IDI level unchanged. This would in theory address the key concern raised by Chair Gruenberg and others in response to the 2018 proposal.
Another approach would be to adopt something that looks like the 2018 proposal at both the holding company and IDI level, on the theory that even if this results in a reduction of leverage capital requirements the effects will be more than canceled out by increases to risk-based capital requirements. Chair Gruenberg’s speech Thursday indicates he is not impressed by that argument, however.
Still another option would be to simply make no changes at either the holding company or IDI level and say that the eSLR rule is good as is, even if it is not perfectly congruent with the Basel leverage buffer standard. The U.S. implementation of Basel III already deviates from the internationally agreed version in places, and U.S. regulators have not in the past had an aversion to making the U.S. rules more exacting than their Basel counterparts.3
It is also possible that the U.S. regulators do not move in lockstep on this question. As mentioned above, whether the FDIC supports or opposes changes in leverage ratio requirements for U.S. GSIB IDI subsidiaries is sort of irrelevant, as there are no U.S. GSIB IDI subsidiaries under the FDIC’s supervision. As long as the Board and OCC are in agreement, a change to well capitalized SLR requirements for U.S. GSIB IDIs could be made without the FDIC’s involvement. And even if the OCC is also opposed to SLR changes, which probably for competitive equity reasons would rule out the Board making any changes at the bank level, the Board alone is responsible for setting requirements at the holding company level. So regardless of what the FDIC and OCC think, in theory the Board can do what it likes with the holding company leverage buffer requirement.
***
One final potential wrinkle on this eSLR point: for most U.S. GSIBs, replacing the flat 2% leverage buffer requirement with a buffer requirement equal to one-half of their GSIB surcharge would result in a reduction in holding company leverage buffer requirement. For instance, both Morgan Stanley and Goldman Sachs currently have a GSIB surcharge of 3%, and so all else equal each would see its holding company SLR + buffer requirement reduced from 5% (3% SLR + 2% flat buffer) to 4.5% (3% SLR + 1.5% buffer).
One GSIB, though, would as things currently stand be left worse off. JPMorgan has disclosed that “the Firm’s effective GSIB surcharge is expected to increase to 4.5% on January 1, 2024.” If this increase occurs as anticipated, and if the Basel approach to calibrating the leverage buffer was adopted here in the United States, JPM’s holding company leverage buffer requirement would actually increase to 5.25% (3% SLR + 2.25% buffer).
Some might say this is a feature rather than a bug. See the 2018 memo from Board staff:
In addition, the proposed calibration would reinforce incentives in the risk-based surcharge framework for GSIBs to reduce their systemic footprint by providing less systemic bank holding companies with a lower eSLR buffer.
That is, if JPM dislikes this outcome, the response from the Board could simply be to say that JPM should not have grown to be so systemically important.
I see where that argument is coming from, but here I think it would be a little harsh, given that under the Basel GSIB surcharge methodology JPM’s surcharge is lower. Indeed, under international standards which correspond to the U.S. Method 1 surcharge calculation, no firm currently has a GSIB surcharge greater than 2.5%. JPM’s GSIB surcharge is so high only because of the gold-plated U.S. Method 2 calculation.
In any case, we are piling hypotheticals on hypotheticals at this point. Wherever the agencies come out on any leverage ratio changes, the impact of those changes cannot be evaluated in isolation. Binding constraints matter, and if the risk-based capital changes are as significant as they have been said to be, maybe leverage ratio requirements will again become a backstop requirement, although perhaps not in the way banks would have preferred.
Mark Your Calendars?
Still on the subject of the forthcoming capital rules proposal, during Chair Powell’s appearance before the Senate Banking Committee on Thursday Senator Hagerty said something interesting.4
For those who can’t view the clip, Senator Hagerty says, “My understanding is that the agencies, including the Fed, are due to vote on this on the 18th of July.”
Chair Powell did not confirm or deny this in his response, no one from what I can tell seems to have reacted to it, and I have not seen the date confirmed elsewhere by the agencies. None of this is to say it is not true, of course.
ESG Working Group Has Thoughts About “Control”
On Friday, the ESG Working Group of the House Financial Services Committee’s Republican majority put out a memorandum styled as an “interim report outlining Republicans’ efforts to protect the financial interest of everyday investors from progressive activists who are using our institutions to force far-left ideology on Americans.”
From a bank regulatory perspective, one set of recommendations stood out:
Congress should review the Big Three’s [BlackRock, Vanguard, State Street] compliance with existing disclosure requirements, with a specific focus on instances where abbreviated Schedule 13G short-form disclosures were filed. This review would help develop a more complete understanding of the extent to which the Big Three exercise influence over the management and corporate policy of their portfolio companies.
Separately, defining “control” within securities laws is another crucial aspect that requires attention. Congress should explore legislation to provide a more precise definition of “control” to prevent potential regulatory loopholes. This would enable a more accurate assessment of the Big Three’s influence over banking organizations, triggering necessary regulatory restrictions and oversight to safeguard retail investors.
One might fairly question whether I am overreading this and whether this is really about bank regulation per se; the main thrust of the complaint here seems to be about Schedule 13D vs. Schedule 13G filings. But I think the last sentence, combined with other comments made by House and Senate Republicans, suggests that the definition of control under the Bank Holding Company Act and other banking regulations may also be a target of further inquiry.
For instance, check out this exchange on Wednesday between Chair Powell and Rep. Huizenga about letters from the Federal Reserve Board to Vanguard and Blackrock from a few years ago.5
Rep. Huizenga: I wanted to follow up an exchange that we had had this past March where we were discussing parameters highlighted in the Federal Reserve Board's legal opinions that outline how asset managers can operate without being deemed quote “in control” of a regular bank or a bank holding company. Letters from the Fed’s legal division also include certain commitments are made by these asset managers to ensure the same result. However, it's no secret that this percentage of ownership held by asset managers will constantly fluctuate as shares are purchased and sold on a on a daily basis. With the ever changing ownership structure, someone must ensure asset managers are complying with not only these opinion letters, your opinion letters prepared by your own staff, but also with the statutory and regulatory framework that the letters outlined. So Chair Powell, I'd like to ask you again, is the Fed taking any steps to assess or monitor whether Vanguard, BlackRock and others are complying with these commitments made in November of 2019 and December of 2020, respectively? Is that ongoing?
Chair Powell: Can you give me one second? [turns to consult with the Board’s General Counsel]
Rep. Huizenga: Okay.
Chair Powell: Sorry, that's a very specific question. I didn't know the answer. But I would say this. We're broadly monitoring the situation. I don't know that we have a particular focus on the on the asset managers.
Rep. Huizenga: Okay. Well, those are those were opinion letters put out by your folks outlining very specific things that could or could not happen. And back in in March, when I brought this up, and now again, today, I'm looking to find out who's actually minding the store on that. So it's a little concerning that, that we don't have an answer on that. I guess, we'll continue this conversation. And maybe you can answer this: what Division at the Fed is responsible for reviewing and monitoring and asset managers compliance with these opinion letters issued by the Board's legal division?
Chair Powell: So it would be the General Counsel's office. We don't have any reason to think that they're not in compliance, by the way.
Rep. Huizenga: But nobody's checking!
Chair Powell: Well, we'll check. But I think we know what we're going to find.
Rep. Huizenga: I'd like to know what you're going to find not what you think you're going to find on that. So thank you. Well, I'll be following up with a letter to include some more detailed questions on the topic.
Along similar lines, recall the report put out by the Senate Banking GOP late last year, which among other things called for Congress and the Federal Reserve Board to “assess whether any of the Big Three control any bank holding companies for purpose of the Bank Holding Company Act or the other banking laws.”
On the merits here I am with Chair Powell. I do not think there is much to suggest that Blackrock or Vanguard are not in compliance with the commitments they made to the Board or that they otherwise currently control any bank or banking organization.
At the same time, the small part of me that finds chaos interesting does think that it could be fun for Congress, as the ESG Working Group recommends, to “explore legislation to provide a more precise definition of ‘control’,” and to do so not under just the securities laws but also the BHC Act.6
After all, although the 2020 revisions to the Board’s control rule improved things a bit,7 the rule still includes various provisions that are a little hard to explain. It is also sometimes still the case that one must rely on a “small handful of people who have spent a long apprenticeship in the subtle hermeneutics of Federal Reserve lore, receiving the wisdom of their elders through oral tradition.”
Of course, given the divided control of government none of this seems likely to go very far, at least in the short term. And in any case a larger, more rational part of me thinks it would probably be better if Congress just left well enough alone when it comes to control under the BHC Act, lest they accidentally stumble into something worse.
Questions From the SEC
This is probably in the old news category, but this week someone pointed out to me a few letters the SEC sent to banks a month or two ago following the spring banking turmoil.
It is important to be clear up front that this correspondence was sent in the context of ordinary course reviews of registration statements filed by the banks in question, and there is nothing to suggest the SEC is particularly interested in these banks as compared to others. Still, because I do not think this has yet been discussed elsewhere, I thought it could be worthwhile to highlight briefly the questions the SEC was asking.8
The SEC’s standard form question to all the banks generally read as follows, sometimes with the final sentence, sometimes without.
In light of recent market events and activities within the banking sector, please revise Business, Risk Factors, Management’s Discussion and Analysis and other sections, where appropriate, to address any material impact these events and activities have had on your financial condition, operations, customer base, liquidity, capital position and risk profile. Provide quantitative and qualitative disclosure as appropriate and clarify what actions management is undertaking in response to the market events and activities. If available, consider supplementing your qualitative disclosure with additional quantitative details in order for an investor to understand changes to your liquidity position, activities, trends and market driven impacts as of a more recent date.
For two banks,9 the SEC provided additional specifics on examples of disclosures it thought would be worthwhile.
Provide an update on your liquidity management and capital position as of a more recent date. Include qualitative and quantitative information about your cash position, investment securities, deposits, borrowings and sources of available but unused borrowings. For example, we note that you had gross unrealized losses of $9.3 million on AFS securities and $6.4 million on HTM securities at December 31, 2022. Any such revised disclosures should include identifying and discussing material stress testing scenarios, metrics or measures that you have utilized to evaluate, monitor and manage your liquidity and capital position;
Discuss material trends and recent activities, as of a more recent date, in your deposits balance, such as deposit inflows, withdrawals, uninsured vs. insured deposits and average rates offered by type of deposit (e.g., demand deposits, time deposits, etc.);
Disclose and discuss any significant market, industry or individual concentrations in your deposit balance and how you manage the concentration risk, if applicable. For example, revise to disclose if there are any significant industries or other concentrations within the population of depositors with any deposits in excess of the FDIC insurance limit of $250,000; and
In regard to your Quantitative and Qualitative Disclosures about Market Risk, expand your discussion of interest rate risk and interest rate sensitivity to help readers better understand and assess potential impacts for all interest rate sensitive assets and liabilities impacting your financial condition and results of operations
Finally, the presence (or not) of a certain C-suite executive was on the SEC’s mind in letters to at least two banks.10
Please disclose whether you have a Chief Risk Officer, which individuals or committees are responsible for the “risk management practices” referenced on pages 18 and 28, and disclose the frequency of meetings by the relevant individuals and/or committees.
Additionally, advise us whether you have a Chief Risk Officer and if not, who handles such duties.
Thanks for reading! You are welcome to email thoughts on this post or any other feedback to bankregblog@gmail.com.
Technically the denominator is what is under the U.S. rules call “total leverage exposure” - essentially on-balance sheet assets plus certain off-balance sheet exposures.
As a Board staff memo explained:
The TLAC rule applies a 2 percent TLAC leverage buffer in addition to the minimum required 7.5 percent SLR component of a GSIB’s external TLAC requirement. The TLAC rule also establishes a minimum leverage-based external long-term debt (LTD) requirement for a GSIB equal to the GSIB’s total leverage exposure multiplied by 4.5 percent. When these TLAC and LTD standards were adopted, they were designed to parallel the standards under the eSLR rule.
Accordingly, the proposal would amend the TLAC rule to (1) replace each GSIB’s 2 percent TLAC leverage buffer with a buffer set to 50 percent of the firm’s GSIB surcharge; and (2) revise the leverage component of the LTD requirement to equal total leverage exposure multiplied by 2.5 percent (i.e., 3 percent minus 0.5 percent to allow for balance sheet depletion) plus 50 percent of the GSIB’s applicable GSIB surcharge.
I have in mind here things like the Method 2 GSIB surcharge, the maturity mismatch add on in the LCR, and so on.
Of course as I’m sure some readers are already protesting, it is also true that for some slightly smaller banks the U.S. regulators’ versions of the rules are more lenient than those adopted by their international counterparts.
Or even other banking laws and regulations. On this point, here is an OCC letter from early May but released last week discussing how Vanguard has successfully rebutted a presumption of control under the CIBC Act.
Equal time: the control rule changes were not universally popular, with some warning that the new rules would “allow hedge fund and private equity investors to exert greater control over community banks’ corporate governance, leading to even more risk-taking.”
The Board vote in favor of the final rule was unanimous although Governor Brainard did issue a separate statement saying “it will be important to monitor the ownership structures of banking organizations in light of this control framework and industry trends, so that the Board can identify and address any financial stability, competition, and other issues that arise in the future.”
The quotes from correspondence discussed in this post are drawn from SEC letters to Colony Bankcorp, BV Financial, Mercer Bancorp, Southern California Bancorp, and Burke & Herbert Financial Services.
The quote here is from the Southern California Bancorp letter. The question to Burke & Herbert was substantially similar, though obviously with different unrealized loss numbers in the first paragraph.
First quote is from the Burke & Herbert letter, second is from the Colony Bankcorp letter.