The New York Fed chose the day before its public meeting to discuss amendments to the supplementary leverage ratio to publish a new call for big US banks to retain a portion of their earnings in a special capital account (SCA) that can be tapped to replenish their core capital instantaneously, and automatically, when it is diminished due to losses.
This would require banks' shareholders to forgo a portion of their claim on dividend distributions and require banks to self-insure their capital adequacy.
Authors Hamid Mehran, of the New York Fed's research group, and Anjan Thakor, professor of finance at the Olin Business School of Washington University in St Louis, suggest the SCA can be thought of as collateral that the regulator asks the banks to put up in exchange for a loan represented by the put option to federal deposit insurance.
Looked at another way, the SCA seems designed to fulfil much the same function as the contingent convertible or regulatory AT1 deals that have been so popular recently from European banks in replenishing their capital in stress conditions.
Its authors suggest the SCA would accrue to shareholders as long as the bank is solvent, but accrue to the regulator – rather than to the bank’s creditors – in case the bank is insolvent and there isn’t an industry-wide problem.
"That is, in case of idiosyncratic failures, bank creditors are forced to take losses," they state. "The fact that creditors don’t benefit from the SCA in that case means that creditors have enough skin in the game to discipline banks.
"Regulators would need to be empowered to seize the special capital account in the event of bank insolvency, just as the Federal Deposit Insurance Corporation (FDIC) Improvement Act of 1991 instructs regulators to shut down sufficiently undercapitalized banks.
"Thus, the idea is a form of 'capital preservation' whose goal is to ensure that the probability of the bank failing is minimized but also preserves market discipline."
The authors' idea is that banks should be allowed to come into compliance with this new requirement by building up retained earnings over an unspecified period, so that raising new equity in the market can be avoided and with it the associated dilution of shareholders and signalling of capital shortage that might undermine a bank's share price.
They add that if poor earnings cause the core capital account to be depleted then transfers from the SCA to the core capital account should proceed purely mechanically after pre-specified rules and be devoid of any regulatory discretion.
The authors’ disruptive recommendation echoes BlackRock CEO Larry Fink’s calls in October 2012 for a global banking rule that would force institutions to recapitalize in a timely fashion if they progressively fall below common tangible equity thresholds. A timely capital-preservation rule should be prescriptive and introduced globally, as a higher priority than resolution mechanisms, he said.
This transparent rule would reduce market disruption if it were to force institutions to pre-emptively establish equity capital buffers to replenish balance sheets in a timely fashion and without taking shareholders by surprise.
The New York Fed aired this notion of an SCA just as US regulators finalized the requirement on the eight largest US banks to meet a leverage ratio of 5% at the holding company level and 6% at the operating level for FDIC-insured deposit-taking subsidiaries by January 1, 2018.
This is much higher than the Basel-mandated minimum leverage ratio of 3%. And even though US regulators said they were considering the same dilutions to the denominator definition of assets that the Basel Committee allowed in January, Daniel Tarullo, Federal Reserve governor, repeated that US regulators might yet impose additional requirements on US banks.
He noted that regulators might “increase the risk-based capital surcharge for US systemically important firms to a higher level than the minimum agreed to internationally, such as by reference to dependence on runnable short-term wholesale funding". He added, rather dryly, that if US banks reduce their large holdings of supposedly low-risk assets in response, then it would follow logically that the supplementary leverage ratio might feel less binding.
Alberto Gallo, senior credit strategist at RBS, says the tough line of US regulators is a positive for investors worrying about financial system stability and points out that some European regulators also seem to be taking the view that the Basel 3% minimum leverage ratio is too lenient.
“We calculate that banks hit by the crisis in both US and Europe [such as Dexia, Lehman, AIG, Merrill Lynch, etc] lost between 3% to 10% of assets,” Gallo notes. "This makes 3% capital/assets appear too low.
“Some European countries are moving to increase absolute capital requirements: the Swiss regulator currently requires its largest two banks to meet a leverage ratio of 4% and is considering raising it above 6%; both the UK and the Netherlands are planning to raise the ratio to at least 4%.”
It seems US banks now face, as well as a tough leverage ratio, the prospect of two additional regulatory capital requirements. One, as Tarullo outlines, might be risk-weighted and vary with dependence on securities financing transactions, reflecting that such markets can close down very rapidly during stress and lead to fire sales and big losses on those supposedly low-risk assets. The second might be an additional general store of retained capital.
While the Fed provides the usual boilerplate that the SCA notion reflects the ideas of authors Mehran and Thakor rather than official Fed think, that’s just for show. The SCA suggestion comes in the culmination of a series of papers the New York Fed has published on large and complex banks, and there’s little pretense that these are purely academic navel-gazing.
“Good research is a vital input to sound economic policy,” says Jamie McAndrews, executive vice-president and head of the New York Fed’s Research and Statistics Group. “This is nowhere more true than in the policy issues surrounding the public debate on large and complex banks.”
