Punishing Banks for Regulatory Failure

Regulators want to saddle midsize banks with new capital rules

WSJ editorial. 

"Silicon Valley Bank failed owing to rising interest rates and lapses by regulators, not a shortage of capital. Yet regulators are using the spring banking panic to justify cumbersome new capital rules that could make the financial system more vulnerable.

The Federal Reserve, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency recently proposed a 1,087-page rule that would raise capital requirements on average by 16% for midsize and large banks. Strong capital levels help protect taxpayers, and we favor them when they are clear and simple. But as Fed Chair Jerome Powell noted in a statement, the potential costs of boosting capital requirements at the current moment could exceed the benefits. 

Some 30 banks with more than $100 billion in assets would be covered by the proposed standards, which effectively nullify Congress’s 2018 bipartisan banking reform that liberated midsize banks from too-big-to-fail rules. That’s the clear political intent of the rule. Flagstar Bank would have to comply with the same capital requirements under the rule as JPMorgan even though it’s 1/25th the size.

Banks would have to hold more capital to account for their “operational” risks such as regulatory penalties, lawsuits and cyber-attacks. The capital charge would be based on a proxy for a bank’s size and past losses from operational problems. Regulators could thus dun banks twice—first with a fine and then by requiring them to hold more capital for future penalties.

The proposal would also impose higher capital requirements for risks from trading, which would be standardized across banks. Banks would have to hold more capital if they engage in activities that regulators deem riskier. That sounds sensible.

But as Mr. Powell explained in a statement, it could spur large banks to reduce market-making activities, “threatening a decline in liquidity in critical markets and a movement of some of these activities into the shadow banking sector.” Regulators no doubt will then try to expand their purview over hedge funds, private equity and other nonbanks that fill the market gap, as they did during the Obama years.

The rule’s risk-weighting regime for trading would also encourage herd behavior and increase regulatory arbitrage. That’s what happened before the 2008 financial panic as banks loaded up on mortgage-backed securities because they were deemed risk-free by regulators. You know how that turned out.

Banks already must comply with numerous overlapping capital regimes, and the Fed proposal would add another at a time of great economic uncertainty. After Moody’s downgraded the credit rating of 10 midsize banks this week and placed six under review, bank bonds took a beating. Tougher capital rules will cause banks to reduce “risk-weighted assets” and lending if raising new capital is too expensive.

Another is that the rules divert bank managers’ attention from actual risk-management, which is what appears to have happened at Silicon Valley Bank. Fed Vice Chair for Supervision Michael Barr’s report on SVB noted that bank managers and supervisors spent “considerable effort seeking to understand the rules and when they apply.”

Yet none of the three banks that failed would have been required to hold more capital under the proposed rules. While the capital charges for trading would hit investment banks hardest, it’s hard to predict exactly how the convoluted rule would affect credit and markets.

To underline the potential for unintended consequences, Republican FDIC Board Member Jonathan McKernan gave the example of a bank that incurs a large regulatory penalty for a consumer compliance problems. As a result, the bank would be subject to lower capital requirements for some residential real-estate and retail exposures.

One certainty is that higher compliance and capital costs will disproportionately burden midsize banks. This will make them less competitive with the giants and increase their incentive to merge to get bigger. But Fed regulators won’t let them merge as long as Treasury Secretary, er, Sen. Elizabeth Warren is looking over their shoulders.

The more regulators try to punish big banks, the more they punish their competitors—and Americans who will ultimately pay for blunderbuss regulation one way or another."