The Future of Payments

Strengthening and Streamlining Bank Capital Regulation 98 BANKING PERSPECTIVES QUARTER 4 2018 process like the usual risk weights, but rather it is free to vary with each year’s design of the stress scenario. To take maximum advantage of this flexibility, it should be used proactively to combat regulatory arbitrage. One way to do so would be to purposefully design each year’s CCAR stress scenarios to react to rapid growth or surprisingly high profitability in particular lines of activity. This could be done at quite a granular level. Indeed, a natural starting point for the exercise might be to have supervisors ask who, for example, the 20 most highly compensated line managers or traders are in each big bank each year, and then to think about stressing the exposures most closely associated with these employees. 2 The underlying idea is to learn as much as possible about the incentives at play by observing the behavior of bank executives, and then to condition the CCAR design based on what is learned from this behavior. MAKE USE OF THE COUNTERCYCLICAL PROPERTIES OF THE STRESS CAPITAL BUFFER: There is one other way to take advantage of the potential for time variation in the stress capital buffer. In the wake of a negative shock to banking system capital, one part of the optimal response is to relax the required capital ratio requirement in a countercyclical manner. This will happen naturally – and in a broadly symmetric way across banks – if there is a single capital requirement that incorporates a stress capital buffer, provided that the underlying stress scenario envisions less further deterioration in the macro environment once the economy has already declined significantly. 3 This sort of macro-sensitivity is already incorporated in the design of the underlying CCAR scenarios. But under the current regime with multiple constraints, it does not have as uniform a countercyclical effect on required capital because not all banks are equally bound by the post-stress capital requirement. Moreover, while there is also a separate formal countercyclical buffer built into the standard risk-based Basel regime, this buffer has not to date been deployed by U.S. regulators. This may in part reflect the political-economy challenges associated with varying an explicit and highly visible statutory requirement. By contrast, if the countercyclical variation is instead an implicit by-product of changes in the annual CCAR assumptions, it may be easier to implement on a semidiscretionary basis. CONSIDER INCREASING G-SIB SURCHARGES: Although it is important to be cautious about the potential distortions associated with imposing different cross- sectional risk weights on different banks, it also the case that, holding the structure of these risk weights fixed, it can make good sense to set a higher overall minimum capital ratio on those banks whose failure creates larger social costs. So, something very much like the existing G-SIB surcharges should continue to play a role in any blended requirement – that is, the baseline capital-ratio requirement should be higher for the largest and most systemic firms. Moreover, to the extent that multiple binding constraints such as the SLR have reflected a general desire to push more capital into the biggest banks, this objective can be accomplished more efficiently using the G-SIB surcharges. This would increase the overall amount of capital in the banking system and would do so without creating the sort of distortionary cross-bank activity- migration incentives discussed above. If anything, higher and more progressive G-SIB surcharges might have a beneficial incentive effect, by encouraging the largest banks to exit those lines of business where they do not create enough in synergies to outweigh the added social costs associated with their size and interconnectedness. STRENGTHEN THE CCAR PROCESS AND INFRASTRUCTURE WITH AN EMPHASIS ON DYNAMIC RESILIENCE: The above recommendations for adapting the CCAR process all refer to how it should be used in normal times. In particular, these recommendations are all in the spirit of integrating the stress-testing process more tightly and efficiently into the normal-times regime of setting minimum risk-based capital ratios. But it would be a mistake to think of this as the only role for CCAR. Another vital aspect of stress testing – indeed, much of purpose of the original 2009 Supervisory Capital Assessment Program (SCAP) – is not to regulate capital ratios ex ante but, rather, to promote a rapid recapitalization of the banking system in the wake of a large negative shock. To put this point into perspective, it is useful to think back to how events unfolded during the early stages of the financial crisis. Problems with subprime mortgages were already surfacing in late 2006. The first serious tremors associated with the crisis were felt in August 2007, with