Easing US bank regulations in the COVID-19 pandemic
In an important but perhaps less noticed response to the pandemic-induced financial crisis, the Federal Reserve Board (Fed) issued an interim rule on April 1 providing temporary regulatory relief for bank holding companies. The Fed's action allows banks to exempt deposits at the Federal Reserve and US Treasury securities from being counted as part of their assets. This action will better enable the US Treasury and the Fed to meet their funding needs in fighting the economic and financial effects of COVID-19. It will also facilitate banks actively supporting the fight. Not making this change could raise the cost of funding for the Treasury.
The relief was limited to how a bank holding company calculates its supplementary leverage ratio. In fact, further steps should be taken to provide funding for crisis response. The Fed, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation (FDIC) should also temporarily remove both Fed and Treasury assets from their calculations of the leverage ratio at the depository institution level as well. In addition, all three banking agencies should also extend this regulatory improvement to the tier 1 leverage ratio. Further, the FDIC should segregate out depository institution holdings of Fed deposits and US treasuries from the assessment base for deposit insurance fees at least for the next year.
The funding needs of the US Treasury and Fed will be substantial over the next few months. Almost by definition the Fed’s funding will come mainly from the banking sector. Further, without the leverage ratio changes, banks could be essentially forced at some point to switch their marginal balance sheet away from providing credit to households and firms to holding more safe assets such as reserves at the Fed and US treasuries.
Should US banks hold capital against deposits at the Fed and US treasuries?
On a standalone basis there is no argument for US banks to hold capital against deposits at the Fed and US treasuries. Or more directly, if a bank only held deposits at the Fed, i.e., if it were a narrow bank, why would it need to hold capital against credit losses?
The reform of banking regulation after the previous financial crisis was formalized at the global level by the Basel III accord. This set of reforms greatly increased the resilience of banks but included compromises to accommodate different circumstances in various regions. For example, the different credit risk of sovereigns within the euro area meant that increased resilience in this region could be achieved by including European Central Bank deposits and sovereigns in leverage ratio calculations.
The Basel III reforms put in place simple leverage ratios as a backstop to risk-based capital rules to ensure that mistakes over assessing risk weights did not lead to undercapitalized banks. There is evidence from financial crises that banks subject to simple leverage ratios where all assets were given equal risk weights performed better than banks not subject to these rules. There is no reason to doubt this evidence or the other clear lesson from the previous global financial crisis that capital should be loss absorbing, thus the Basel III focus on common equity tier 1 capital.
But the evidence on the efficacy of simple leverage ratios stems from a time when central banks, operating under a different monetary policy framework, held miniscule reserves compared to the total assets of the banking sector. With the new ample reserve regime and the urgent need for a larger Fed balance sheet, these historical comparisons are just wrong when it comes to including Fed deposits as assets to hold capital against.
The effects of the simple leverage ratio can be counterproductive. The Fed issues more reserves to fund a lending facility (for example the new Main Street Facilities) and the reserves end up as an asset in the banking system. Then a bank that would lend alongside the Fed facility now finds its leverage ratio is constraining if it makes the loan because the increased reserves have eaten up some of its capital. The logical action for the bank is not to make this loan or increase the interest rate on the loan. A similar chain of decisions can be made for increased issuance of treasuries.
Should deposit insurance fees be assessed against bank deposits at the Fed and holdings of US treasuries?
The FDIC deposit insurance fee is not a capital charge and does not provide the same incentives to change asset composition as the simple leverage ratios. In 2011 the base for assessing FDIC fees was increased to effectively include all liabilities net of capital, in effect scoping in the asset side of a bank’s balance sheet irrespective of how risky the asset is. The result of this wider assessment base is a larger deposit insurance fund. A larger deposit insurance fund is a good result. Further, the wider assessment base was designed to better align incentives for banks using a larger mix of wholesale funding.
Keeping deposits at the Fed and US treasuries in the assessment base in the middle of a crisis is counterproductive. If necessary, the FDIC can raise insurance fees after the crisis to restore the deposit insurance fund. Further, in cases where the deposit insurance fund becomes dangerously depleted, the FDIC can draw on lines of credit from the US Treasury. To finish another circle of absurdity, if the Treasury issuance used to fund this line to the FDIC were held by a bank, then the bank would have to pay fees to the FDIC for the privilege of holding the treasury debt that funds the deposit insurance fund. The FDIC has learned hard lessons over the last few decades to avoid such feedback loops.
How would the FDIC segregate out treasuries and Fed reserves?
There are two basic approaches for segregating out treasuries and Fed reserves from the risk assessment base: First, the FDIC could allow individual depositors to choose a special account that is fully backed by reserves and treasuries held to maturity; second, they could just segregate out reserves and treasuries at historic cost accounting each day from the measure of total assets.
The first approach is similar to the segregated balance accounts of James McAndrews. This type of narrow banking is worth a public debate, but it would be a difficult and risky choice to make during a crisis. However, since the safety benefits it brings to large depositors could be replicated by the FDIC using its systemic risk exception power to guarantee without limit transaction accounts—a power that the Coronavirus Aid, Relief, and Economic Security (CARES) Act temporarily restored—the second approach to segregation is preferred for now.
There needs to be a robust international discussion of whether these changes to simple leverage ratios should be made permanent. As discussed by Nicolas Véron the unilateral decision by the Fed might have affected the incentives for international coordination. Any changes should not be a one-way street: Large US banking organizations should commit to suspending capital distributions by share repurchases through year end 2020 as discussed by Nellie Liang.
1. If a leverage ratio is binding, banks would need the yield on US treasuries to cover the cost of increasing capital. This is highly unlikely, thus demand for US treasuries will be lower, increasing the cost of funding.
2. Three custody banks in the United States earlier received some permanent relief from section 402 of the Economic Growth, Regulatory Relief, and Consumer Protection Act for central bank deposits to Basel III rules. This temporary relief would further help them to more effectively support their custody services.
3. The Fed has various liabilities that fund its assets. The largest are reserves held in the banking system. The Fed, if necessary, could increase the individual counterparty cap in the overnight reverse repurchase facility to increase funding from money market mutual funds.
4. The usual argument is that simple leverage ratios push banks into riskier assets. The current situation is different since banks will be using up much of their buffers above risk-based capital ratios, both regulatory and internal. In this situation if safe assets on the balance sheet make simple leverage ratios binding, then it is most efficient to move the mix more to less risky assets and reduce total assets.
5. There are some complications related to the capital structure of entities within large bank holding companies and the responsibilities of different regulators. For the largest bank holding companies these were handled by using a single point of entry in resolution. For other bank holding companies ensuring that the capital structure of entities within the bank holding company promotes safe and sound practices is standard supervision. Of course without the additional relief, one option would be for the holding company to issue additional debt and downstream capital to the depository institution as its leverage ratio starts to bind with increases in reserves and US Treasury holdings. It makes more sense to exercise this option to support lending to households and firms, and not to the Fed and Treasury.
6. This issue could understandably influence an international agreement such as Basel III, particularly as was the case when the US was pushing for tougher risk-based capital standards.
7. In standard approaches to risk-weighted capital reserves, central bank deposits receive zero weight, and own country sovereign debt held to maturity also receive zero weight.
8. Using this logic, the banking agencies have removed Paycheck Protection Program lending from total assets in calculating leverage ratios and risk-based capital ratios.
9. The FDIC fees are small, but with very low rates they would eat up a substantial portion of interest on reserves and US Treasury yields.
10. The value of reserves does not change from day to day since they are in the unit of account: One dollar is always one dollar. The value of US treasuries can vary, but if held to maturity, then their nominal value returns to par. For banking organizations with accounting systems that can handle Generally Accepted Accounting Principles (GAAP), such as constant effective yield and the time-varying inflation compensation from Treasury Inflation Protected Securities (TIPS), this change would be simple. For those without these systems, straight line amortization could be used for nominal coupons. For TIPS even simpler methods could be used.
11. Under Basel III the US banking agencies have the right to temporarily exclude Fed reserves but not US treasuries.