Quarles sees ‘real merit’ in switching on 1% capital buffer during normal times to deal with credit cycle

There is “real merit” to exploring the use of a 1% countercyclical buffer that is in effect in normal times, much like that used in the United Kingdom, the Federal Reserve’s top regulatory supervisor said Friday.

In a speech in Washington, D.C. (on “Law and Macroeconomics” at Georgetown University Law Center), Federal Reserve Board Vice Chair for Supervision Randal Quarles said that the U.S. has set a countercyclical capital buffer (CCyB) at 1%. The CCyB is a capital buffer ranging from 0% to 2.5% that regulators can switch on or off to counter overheating credit markets. So far, the U.S. has kept the switch set to “off.”

But Quarles indicated he would consider turning the switch “on.”

Quarles noted that France, Hong Kong, Sweden, the United Kingdom, and Norway have all turned the switch to “on.”

“It is worth noting that, in the United Kingdom, the CCyB is set equal to a positive level – 1% – in normal times,” Quarles said. “As a result, their buffer can be adjusted upward or downward based on the perceived risks of the time-varying credit cycle.”

“As I have recently said, I see real merit in exploring the U.K. approach as a tool to promote financial stability,” the Fed’s top supervisor said.

Quarles told that group that, in setting the buffer, the Fed takes into account leverage in the financial sector, leverage in the nonfinancial sector, maturity and liquidity transformation in the financial sector, and asset valuation pressures.

“Notably, the CCyB is not calibrated bank-by-bank and is not calibrated asset-class-by-asset-class,” he said. “Rather, regulators set the buffer based on their perception of the aggregate domestic credit cycle, whether it’s too hot, too cold, or just right.

“Under the Board’s current policy, we would activate the CCyB based on ‘when systemic vulnerabilities are meaningfully above normal,’” he said.

In other comments to the group, Quarles said he would welcome greater legal scholarship on due process considerations associated with bank supervision “as a process distinct from bank regulation.”

“By bank supervision, I refer to the processes and activities identified with examining banks, including checking compliance with laws and regulations, assessing bank capital and liquidity levels, assigning supervisory ratings to banks, and taking formal and informal enforcement actions,” he said.

He said making sure banking supervisors are acting fairly toward those they regulate is equally important to assessing the world’s largest banks, particularly in light of financial stability risks.

“Although questions of fairness are routine in law and economics, there is ample room to explore these issues as they relate to bank supervision,” he said.

FRB Vice Chair for Supervision Randal K. Quarles: Law and Macroeconomics: The Global Evolution of Macroprudential Regulation