Despite a huge roster of unreconcilable differences, the Treasury Department, House and Senate Republicans, and even Congressional Democrats stand together with federal regulators on one financial-policy conclusion: they all agree that “tailoring” is just the thing in banking regulation this season. Some want tailoring by size, some by complexity, some by a combination of risk indices. But none to my knowledge has said whether the tailoring by any of these patterns is for a suit, a dress, a raincoat, or even a bikini. Put another way, regardless of how we tailor, why are we tailoring bank regulation – to ensure safety and soundness? Credit availability? Competitiveness? Burden relief? Nice goals all, but we can’t have them all at the same time. Truly elegant regulatory tailoring means recognizing the daunting trade-offs that apply if you want a nice dress in a hot style made of a wrinkle-free fabric at a reasonable cost for a woman with an extra pound here or there – that is, there are costs and benefits that must be weighed against each other for an optimal solution.
A new FedFin paper lays out an analytical methodology to assess these trade-offs with regard to one important rule that needs some tailoring: the U.S. advanced approach to risk-based capital. As I’ll describe below, we think its methodology can also be applied not only to quick action to rationalize the risk-based capital rules, but also many of the other demanding trade-offs policy-makers now confront as they try to balance regulatory relief with financial stability.
In our new paper, we look at whether the advanced approach to the U.S. capital rules (also called the A-IRB) is a value-add to the rest of the U.S. risk-based capital regime for large, but non-complex U.S. regional banks. The relationship between the standardized approach (SA) and the A-IRB is of course so hot a topic in the global arena that it’s brought Basel to the brink of breaking apart over whether there should be an “output floor” under the global advanced approach.
This battle has clouded U.S. discussion of the marginal costs and benefits of the U.S. capital regime, so our paper first differentiates the U.S. rules from global ones and then assesses marginal cost-benefit analysis (CBA) in light of other U.S.-specific regulatory and market factors.
The heart of the marginal CBA methodology is to hold one policy factor constant and then consider how it changes in light of all the others germane to it, using academic and governmental research wherever possible to lay out cost-benefit interactions and consequences.
Most regulatory analyses are single-silo affairs – that is, the Fed or another regulator looks at the one rule it’s promulgating to see how much it might cost in terms of a few selected quantitative measures. It’s no wonder then that most regulators find that all of their rules pass CBA muster. Viewed on a marginal-CBA basis and taking qualitative considerations carefully into account, one quickly sees cumulative effects and, from that, potential problems.
And we found several critical ones after deploying our marginal-CBA methodology on the U.S. advanced approach. As noted in the paper, the Regional Bank Coalition funded this work. As always, FedFin retained full editorial and methodological control. The conclusions I describe here and those in the paper are “on us.”
First, we looked to see how binding the A-IRB is for large, non-complex regional banks. No matter how warranted, each capital calculation has direct compliance costs and far more important indirect costs on balance-sheet capacity and governance resources. Thus, a first-order question we took on is whether the A-IRB matters all that much for large, non-complex banks. In short, not so much. An often-overlooked difference between the U.S. and global rules is that the U.S. requires all banks subject to the A-IRB to use the higher of the standardized approach (SA) or advance weightings. No output floor needed!
However, the U.S. capital rules do not include only the SA and A-IRB. They also include a couple of dozen other risk-based capital measures, liquidity rules, the leverage ratio, and perhaps most importantly CCAR. Which of all these capital rules binds whom when is a moving target, but the data presented in our paper show that the advanced approach is rarely, if ever, a regional BHC’s binding constraint. And, even where it is, it doesn’t matter much – regulators have ample authority to stipulate additional risk-based capital for any bank or BHC taking idiosyncratic risks or engaged in a business line the agencies fear might not be well captured in whatever binding constraint happens to apply.
Given this panoply of capital and related regulation, our marginal CBA finds that the advanced approach costs large, non-complex regional banks a lot that cuts more deeply into return and thus adversely affects franchise viability and, indirectly, credit availability.
All of these costs might be worth it, though, if the benefits outweigh them. We thus looked to see if applying the A-IRB makes large, non-complex banks any safer or easier to resolve. In short, it doesn’t – in fact, we find that the advanced approach is destabilizing because it’s so procyclical and also due to the diverted managerial and supervisory resources. Taking their eyes off emerging risk to be sure that each A-IRB model works just right, these banks and their regulators may well miss the next asset bubble or market risk.
As noted, Washington is agreed on the tailoring point even if it doesn’t have a preferred pattern. But, tailoring gets a lot more contentious when talk turns not just from tailoring to what should be tailored. Using a marginal-CBA analytical approach, it is clear that the advanced approach requires considerable tailoring for large, non-complex U.S. regionals. Similar analytics for other types of banking organizations could well show similar results – that is, a specific rule’s intended goals are not achieved taking into account all the other rules and the market reality they construct. Marginal CBA analytics leave out the rhetorical flourishes, but they demonstrate unintended effects so clearly that even those opposed to taking in a particular regulatory seam may well see why a specific bit of tailoring makes a positive difference.