June 8, 2020

Comment on Regulatory Capital Rule: Temporary Exclusion of U.S. Treasury Securities and Deposits at Federal Reserve Banks From the Supplementary Leverage Ratio

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I appreciate the opportunity to comment on the notice of proposed rulemaking for Regulatory Capital Rule: Temporary Exclusion of U.S. Treasury Securities and Deposits at Federal Reserve Banks from the Supplementary Leverage Ratio. I am a senior research fellow at the Mercatus Center, a university-based research center at George Mason University. My comments do not reflect the views of any affected party but do reflect my general concerns about the effectiveness of regulation and the associated burden and unintended consequences of regulation. I will briefly summarize the points I will make in response to Questions 1 and 2 posed in the notice of proposed rulemaking and then provide more detail supporting my responses.

  • Question 1 concerns the advantages and disadvantages of removing Treasuries and deposits at Federal Reserve banks from the total leverage exposure in the supplementary leverage ratio.

    Advantages: One potential advantage arises from avoiding calls for a bank to raise capital as a result of banks accommodating the extraordinary measures undertaken by the federal government in response to the COVID-19 pandemic and bank customer asset liquidations.

    Also, because I believe capital requirements at the bank subsidiary level work more effectively than at the holding company level in terms of protecting depositors and the deposit insurance fund, I view the potential harm here, in terms of greater risk of financial instability, as less than if the rule change applied at the subsidiary level.

    Disadvantages: One disadvantage of the change arises from the fact that the exclusion turns the leverage ratio into yet another risk-based capital ratio by effectively assigning Treasuries and deposits at Federal Reserve banks risk weights equal to zero. I will show, using a simple model of a profit-maximizing bank that’s subjected to both a leverage ratio and a risk-based capital ratio, that as one excludes more Treasuries and reserves from the denominator of the leverage ratio, the bank allocates more toward these assets and allocates less to loans. While that seems to be the aim of the rule change, since loans tend to have among the highest risk weights, the model shows how risk-based capital, rather than the non-risk-based leverage ratio, encourages large banks to substitute away from high-risk-weight assets, such as loans. As people in the United States eagerly await a recovery, regulatory-capital-requirement-related disincentives to hold loans could factor into a slower recovery from the COVID-19 pandemic if the largest banks shift their portfolios away from loans and other banks cannot step in to fill the void. The model also shows that excluding Treasuries and reserves from the leverage ratio also makes banks more leveraged. 
     
  • Question 2 concerns other assets that could be excluded. Adding more assets to the list of those excluded from the total leverage exposure will make the supplementary leverage ratio even more like the complex risk-based capital requirements— and therefore redundant. If the goal is to limit potential unintended consequences and create regulatory redundancies, the net benefits of making fewer changes likely exceed the net benefits of making more changes.

Read the full comment here.