Fed’s top supervisor defends capital rule proposals as promoting resiliency, making regulation simpler

Defending recent proposals to “recalibrate” capital for large banks, the Federal Reserve’s top supervisory official said Friday that the proposed rules will play a key role in helping the central bank accomplish its dual roles as overseer of the economy and financial institution regulator.

“As I have said previously, I view promoting the safety, soundness, and efficiency of the financial system as one of the most important roles of the Board,” Federal Reserve Board Vice Chairman for Supervision Randal Quarles said. He also noted the roles give the agency visibility into the economy and allow it to calibrate regulations in response to what it sees.

Quarles’ comments were made in prepared remarks delivered to the Hoover Institution’s Monetary Policy Conference at Stanford University, Palo Alto, Calif.

“So how is efficiency of the financial system connected to monetary policy? To put it in the simplest fashion, to the extent that the efficiency of the financial system is improved, it will improve the transmission of monetary policy to the real economy,” Quarles said.

Pointing to the Fed’s recent proposals on a stress capital buffer and an enhanced supplementary leverage ratio (eSLR), Quarles asserted that the task for the central bank is to enhance efficiency while maintaining system resiliency.

“The proposal to modify the eSLR, in particular, initially raised questions in the minds of some as to whether it would reduce the ability of the banking system to weather shocks,” Quarles said. “A closer look at the proposal shows that the opposite is true. The proposed change simply restores the original intent of leverage requirements as a backstop measure to risk-based capital requirements. As we have seen, a leverage requirement that is too high favors high-risk activities and disincentivizes low-risk activities.”

The Fed supervisory leader argued that the Fed’s existing leverage ratio was calibrated at a level that caused it to be “the binding restraint for a number of our largest banks.” He said those banks then had an incentive to add risk rather than reduce it in their portfolios because the capital cost for additional assets was equal whether risky or safe – and that the riskier assets would produce the higher return.

“The proposed recalibration eliminates this incentive by returning this leverage ratio to a level that is a backstop rather than the driver of decisions at the margin,” Quarles said. “Yet, because of the complex way our capital regulations work together – with risk-based constraints and stress tests regulating capital at both the operating and holding company levels – this improvement in incentives is obtained with virtually no change in the overall capital requirements of the affected firms.”

The Fed vice chairman said agency staff estimate that the proposal would potentially reduce capital requirements across the eight large banks subject to it by $400 million, or 0.04% of the $955 billion in capital these banks held as of September 2017.

So this recalibration is a win-win: a material realignment of incentives to reduce a regulatory encouragement to take on risk at a time when we want to encourage prudent behavior without any material capital reduction or cost to the system’s resiliency,” Quarles said. “Taken together, I believe these new rules will maintain the resiliency of the financial system and make our regulation simpler and more risk sensitive.”

Speech by Vice Chairman for Supervision Quarles on liquidity regulation and the size of the Fed’s balance sheet