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From Banking and Finance Law Daily, June 8, 2016

Senate considers complexity, effectiveness of capital and liquidity regulations

By Colleen M. Svelnis, J.D.

A Senate Banking Committee hearing on June 7, 2016 examined the effect of capital and liquidity standards put into place after the financial crisis. Committee Chairman Richard Shelby (R-Ala) opened the hearing, entitled "Bank Capital and Liquidity Regulation," by reminding everyone that during the financial crisis, it became clear that the amount of high-quality capital held by many banks was insufficient.

Shelby said the question to ask is whether banks are in position today to withstand another major financial crisis. However, he expressed concern that excessive complexity could lead to a weakening of capital standards and urged the committee to "consider the cumulative impact" of the regulations. According to Shelby, "unnecessary layers of complexity can create undue burdens for banks big and small, a more complex regulatory system could actually lead to an increase in systemic risk."

"Experts on both the left and the right agree that capital is a vital element of financial stability," stated Ranking Member Sherrod Brown (D-Ohio) in his opening statement. Refuting arguments that stronger capital requirements put banking institutions at a competitive disadvantage, Brown stated that "there is evidence that U.S. banks’ higher capital has actually been a competitive advantage—for example, the president of one of the largest U.S. banks said in February that our banks benefitted from moving quickly to raise more capital."

Brown said that, "in its five-year anniversary report on Wall Street reform, the ratings agency S&P credited capital and liquidity rules, as well as stress tests and living wills, with enhancing the safety of the U.S. banking system." Capital lessens the likelihood that an institution will fail, and lowers the costs to the financial system and the economy if it does, said Brown. Pointing to the latest living wills results showing that several of the U.S.’s largest banks still have deficiencies in their capital and liquidity, and could not fail without threatening our financial system, is proof, Brown stated, that we need these regulations.

Capital requirements won’t prevent crisis. Hal S. Scott, Harvard Law School Professor and the Director of the Committee on Capital Markets Regulation stated in his testimony that "Dodd-Frank has pared back many of the very powers that were successfully deployed during the crisis like the Fed's ‘lender-of-last-resort’ liquidity authority and expanded deposit guarantees." Scott focused his testimony on two aspects capital and liquidity regulation:

  • a general overview of the effectiveness of capital and liquidity regulations in reducing systemic risk; and
  • discussion of the process by which regulators impose capital and liquidity requirements, specifically the Federal Reserve stress testing of financial institutions.

"Although capital requirements can serve these important purposes, at any realistic level they cannot prevent the financial contagion that we experienced in 2008, where widespread fears over the stability of the financial system led to a run on short-term funding in both the bank and non-bank sector." According to Scott, the main problem with a leverage ratio is that it requires precisely the same amount of capital for all asset classes, irrespective of their various risk profiles.

Increase equity capital. Heidi Mandanis Schooner, Professor at the Columbus School of Law at The Catholic University of America, emphasized in her testimony the importance of equity capital and the failure of current capital regulations to restrict heavy borrowing by financial institutions whose distress or default would cause collateral harm. Schooner said that while adequate capitalization is of central importance for financial institutions, "little justifies the current low levels of capital required under banking rules." Instead, she promoted a "burden-shifting, precautionary approach to capital regulation" in order to protect the public from the "negative effects of chronic under-capitalization that remains tolerated in banking." Schooner pushed for significantly increasing equity capital, stating that more equity capital and less debt makes banks more resilient and better able to withstand inevitable economic crises.

Overly complex regulations. Paul H Kupiec, Resident Scholar at the American Enterprise Institute testified that "complex banking regulations are only justified when the complexity is necessary to mitigate the problem that requires a regulatory response." According to Kupiec, the Dodd-Frank Act compounded the problem by introducing new regulations and responsibilities "with the sole objective of preventing another financial crisis regardless of any countervailing considerations" or costs.

Kupiec also stated that there are studies suggesting that deposit insurance fund losses could be reduced by replacing Basel regulatory capital ratios with the nonperforming asset coverage ratio (NACR) in the prompt corrective action rules, and that NACR identifies weak and failing depository institutions more efficiently than Basel-based regulatory capital measures.

Kupiec warned that new minimum total loss absorbing capacity (TLAC) rules will make the capital regulations even more complex for large bank holding companies and stated that "Virtually all of the regulatory goals of TLAC could be achieved by imposing higher minimum regulatory capital requirements on [Global Systemically Important Banks’] critical operating subsidiaries."

Companies: American Enterprise Institute; Committee on Capital Markets Regulation

MainStory: TopStory BankingOperations CapitalBaselAccords DoddFrankAct FederalReserveSystem FinancialStability

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