Financial Services and Risk Management Subcommittee: Understanding Bank Capital Incentives Under Conflicting Capital Regimes Recommendation

Background

The post-crisis regulatory capital framework introduces three “static” regulatory capital metrics that are potentially binding on large US banks: the Basel III Advanced ratio; the Basel III Standardized ratio; and the Supplementary Leverage Ratio. Both of the Basel ratios are also affected by the G-SIB buffer – the additional capital requirement that will be levied on the 8 largest US banks based on measures of their systemic importance. Layered on top of this, the Federal Reserve’s annual CCAR exercise imposes a dynamic test that evaluates these ratios under the Fed’s prescribed stress conditions, subject to minimum thresholds.

Because the calculation basis for each of the regulatory capital metrics is different by design, the metrics can have varying implications for the internal costs of capital and behavioral incentives within a bank. For example, the Basel III Advanced ratio is a risk-based measure that weights capital requirements for different assets based on the results of internal models. The Supplementary Leverage Ratio, by contrast, is an unweighted measure that imposes a single capital (or leverage) requirement for all assets irrespective of risk. Since capital is (generally) fungible within a bank, a key policy question is which ratio is binding on the bank overall – i.e., which capital ratio determines the overall amount of capital a bank must hold to comply with regulatory standards, given its risk profile and business mix. The binding capital requirement will determine the internal costs of capital for different activities and a bank’s behavioral incentives.

Importantly, the binding ratio for an individual bank can switch due to changes in economic conditions, since the ratios are sensitive to subtle changes in business mix and risk profile. The potential for shifting capital requirements adds an element of complexity and uncertainty in anticipating how banks would behave under varying market conditions, including times of stress. Understanding these behavioral effects and their systemic implications should be a core part of the OFR’s mission.

Recommendation

Given the systemic importance of bank capital management, the Financial Research Advisory Committee recommends that the OFR undertake a research program to assess the interplay of different capital metrics on bank behavior. In particular, the OFR should focus on bank capital incentives in times of stress. Understanding bank capital incentives is critical to anticipating how banks would de-risk and de-lever in a crisis, and to anticipating the implications of their actions for systemic risk.

With this as a broad objective, we suggest that the OFR design a research program that:

1. Examines the range of capital metrics for different banking business lines (e.g., investment banking, commercial banking, retail banking, transaction banking) under current “business as usual” conditions; as well as the topof-the-house capital metrics for US SIFIs. The top-of-the-house information is publicly reported; information on business line capital requirements is known to the regulatory community and could be obtained by the OFR from the relevant agencies

2. Determines which capital metric is binding for different business lines and firms, and how sensitive the binding metric is to changes in either business mix or risk profile

3. Assesses, under a variety of stress scenarios, which capital requirements are likely to become binding at both the business line and firm level The output of this research could then be combined with agent-based factor models or other approaches to try to anticipate how banks would manage their balance and capital in times of stress. At a minimum, knowing which capital metrics would likely be binding would help inform policymakers about key pressure points and incentive effects as part of their crisis planning.