Banks are profitable and the economy is strong – but with cyclical pressures building, it might be a good time to ask large banking organizations to “fortify” their capital buffers, a member of the Federal Reserve Board suggested Friday.
In a speech before the Peterson Institute for International Economics (PIIE) in Washington, which focused on financial stability, Fed Governor Lael Brainard asserted that – even though the U.S. financial system is much more resilient than it was before the financial crisis of 10 years ago – “the banking system’s core capital and liquidity buffers have yet to be tested through a full cycle.”
“At the same time, the appetite for risk among financial market participants rose notably over 2017 and much of 2018, and corporate borrowing has reached new heights amid rapid growth and deteriorating underwriting standards in riskier segments, such as leveraged lending,” she said.
Brainard pointed out that the Fed’s Financial Stability Report,issued last week (for the first time), suggested that financial vulnerabilities associated with corporate debt are building, and doing so against a backdrop of elevated risk appetite.
She said a strong case can be made that the financial system’s buffers be strengthened when the economy is strong, such as now. “Reinforcing capital buffers during the strong part of the cycle means that banks will have a cushion to absorb losses and remain sound during a subsequent downturn,” she said. “Thicker capital buffers help bolster the confidence of market participants when conditions deteriorate, helping prevent the downward spiral from a loss of confidence.”
She suggested that, during a downturn, the extra capital buffer could be released to allow banks to continue lending and help mitigate the severity of a economic slump.
“History suggests that the market on its own is unlikely to provide incentives for banks to build necessary buffers when times are good, and that’s precisely because market sentiment becomes overconfident when risk is starting to build, that in kind of ‘essence’ of the cycle,” she said. “One of the roles for independent regulatory bodies is to serve as a counterweight. Moreover, as we saw in the last crisis, it is much costlier to rebuild capital in a downturn when earnings and risk appetite are low than to build buffers when earnings are still strong.”