One solution to improving the determination of capital adequacy is to assign a larger role to the judgment to markets. The CCMR has conducted a study on capital regulation that examines a balanced approach to enhancing private market discipline, through better disclosure and requirements for capital instruments that cannot be bailed out, while
strengthening the role of regulators.70 A regulatory approach recognizing the dual roles of government and the private market in determining adequate capital might result in a stronger and safer financial system than can be achieved through public regulation alone.
In general, the private market is much more effective and efficient at pricing risk than regulators, so policymakers should pursue a market-based approach that enhances the market discipline of banks, relying on the market to dictate optimal levels of capital.
Market signals, such as debt yields or CDS prices, may also better inform a regulator of capital deficiencies than strict adherence to government-imposed requirements.
The heaviest consideration weighing against reliance on capital requirements to control contagion, however, is that while capital cushions short-term creditors against having to absorb losses, perhaps deterring the impulse to run, it does not foreclose the risk of
suffering impairment altogether. As long as a financial institution is reliant on short-term funds, in any significant amount, to support long-term investment, short-term creditors who supply those funds are exposed to potential losses incurred through fire sales. In a crisis, the rational option will be to run. When that happens, capital requirements can certainly lower public costs by ensuring that deeper reserves of private funding and
capital are available to the distressed institution. What they cannot do is prevent the run in the first place, or stop it from becoming generalized to the financial system.
If the problems posed by contagion are solved through more effective means, then individual banks can be allowed to fail as a result of bank mismanagement without concerns that their failure will spread to other banks. Having effective anti-contagion weapons is just as important in dealing with the too-big-to fail problem as effective resolution procedures.
Capital will not stop contagion but it is still vitally important. A correlated negative shock causes the failure of many large financial institutions at the same time. This problem cannot be addressed by a lender of last resort because insolvent banks should not be eligible for such lending absent adequate collateral. Despite the limitations of capital requirements in addressing contagion, increased capital may provide a level of protection against correlation risk, since stronger banks can better withstand common external shocks, and ultimately limit the need for public injection of capital.
Notes
1. Viral Acharya, Hamid Mehra, Til Schuermann, and Anjan Thakor, Robust capital regulation (Ctr. for Econ. Policy Res., Discussion Paper Series 8792, Jan. 2012).
2. Martin Hellwig, Capital regulation after the crisis: Business as usual? Max Planck Institute for Research on Collective Goods (Jul. 2010).
3. Id.
4. See Samuel Hanson, Anil K. Kashyap, and Jeremy C. Stein, A macroprudential approach
to financial regulation, J. Econ. Persp. (forthcoming).
5. Martin Hellwig, Capital regulation after the crisis: Business as usual? Max Planck Institute for Research on Collective Goods (July 2010).
6. Basel Comm. on Banking Supervision, Strengthening the resilience of the banking sector: Consultative document (Dec. 2009), available at
http://www.bis.org/publ/bcbs164.htm; Press Release, Basel Comm. on Banking Supervision, Group of Governors and Heads of Supervision announces higher global minimum capital standards (Sep. 12, 2010), available at
http://www.bis.org/press/p100912.pdf; Jaime Caruana, Gen. Manager, Bank for Int’l Settlements, Speech at the 3rd Santander International Banking Conference: Basel III:
Toward a Safer Financial System (Sep. 15, 2010), available at
http://www.bis.org/speeches/sp100921.pdf; Basel Committee on Banking Supervision, Bank for Int’l Settlements, Annex (Jul. 26, 2010), available at
http://www.bis.org/press/p100726/annex.pdf.
7. Joint Press Release, Bd. of Governors of the Fed. Res. Sys., Fed. Deposit Ins. Corp., OCC, Agencies Seek Comment on Regulatory Capital Rules and Finalize Market Risk Rule (Jun. 12, 2012), available at
http://www.federalreserve.gov/newsevents/press/bcreg/20120612a.htm; see Dodd–
Frank Act Hearing Before the S. Comm. on Banking, Housing & Urban Affairs, 112th Cong. (Jul. 21, 2011) (statement of Ben Bernanke, Chairman, Bd. of Governors of the Fed. Res. Sys.) (noting that “the Federal Reserve … working with other banking
agencies, is on schedule to implement Basel III”). For final rule, see Regulatory Capital Rules: Regulatory Capital, Implementation of Basel III, Capital Adequacy, Transition Provisions, Prompt Corrective Action, Standardized Approach for Risk-Weighted Assets, Market Discipline and Disclosure Requirements, Advanced Approaches Risk- Based Capital Rule, and Market Risk Capital Rule. 78 Fed. Reg. 62017 (Oct. 11, 2013).
Though Basel II was published in June 2004, it has not been fully implemented in the United States, although eight BHCs exited their parallel runs in February 2014. (The parallel run is essentially a trial run during which supervisors oversee a bank’s
implementation of the standards, although they are not yet mandatory.) In June 2011, the FDIC approved a rule implementing the Dodd–Frank Act’s “Collins Amendment,”
which mandates that banks with over $250 billion in assets (those eligible under Basel II to use internal risk models) calculate regulatory capital requirements based on the Basel I standard used by smaller banks, and adhere to whichever capital requirement is higher. Federal Deposit Insurance Corporation, FIL-48–2011 (Jun. 17, 2011), available at http://www.gao.gov/assets/670/667112.pdf.
8. See Basel Comm. on Banking Supervision, International convergence of capital measurement and capital standards 1, 3 (1998), available at
http://www.bis.org/publ/bcbsc111.pdf.
9. For introductory discussion to the concept of risk-weighting, see Richard Carnell,
Jonathan R. Macey, and Geoffrey P. Miller, The Law of Banking and Financial Institutions 1, 257–63, 272 (New York: Aspen, 2009).
10. See Basel Comm. on Banking Supervision, International convergence of capital measurement and capital standards 1, 3 (1998), available at
http://www.bis.org/publ/bcbsc111.pdf.
11. See Basel Comm. on Banking Supervision, International Convergence of Capital
Measurement and Capital Standards 1, 3 (1998); Jaime Caruana, Gen. Manager, Bank for Int’l Settlements, Speech at the 3rd Santander International Banking Conference:
Basel III: Toward a Safer Financial System (Sep. 15, 2010).
12. Basel Comm. on Banking Supervision, International Convergence of Capital measurement and capital standards 1, 3 (1998).
13. See Basel Comm. on Banking Supervision, Basel III: A global regulatory framework for more resilient banks and banking systems 58 (Jun. 2011).
14. Ernest Patrikis, Higher minimum capital standards: Basel Committee on Banking Supervision crowns common equity king, BNA Insights (Nov. 30, 2010).
15. 12 CFR Part 208, 217, and 225; 78 Fed. Reg. 198 (Oct. 11, 2013), 75473; Davis Polk &
Wardwell, U.S. Basel III final rule: An introduction, available at
http://www.usbasel3.com/tool/images/generalInfo.htm. The rule will apply to all banks, regardless of size. Small bank holding companies (generally those with under
$500 million in consolidated assets) and certain savings and loan holding companies that are substantially engaged in insurance underwriting or commercial activities are excluded from the requirements.
16. Basel Comm. on Banking Supervision, Global systemically important banks:
Assessment methodology and the additional loss absorbency requirement (Jul. 2011), available at http://www.bis.org/publ/bcbs201.pdf. In November 2011, the FSB released its first list of G-SIBs, which included the following 29 banks: Bank of America, Bank of China, Bank of New York Mellon, Banque Populaire CdE, Barclays, BNP Paribas, Citigroup, Commerzbank, Credit Suisse, Deutsche Bank, Dexia, Goldman Sachs, Group Crédit Agricole, HSBC, ING Bank, JP Morgan Chase, Lloyds Banking Group, Mitsubishi UFJ FG, Mizuho FG, Morgan Stanley, Nordea, Royal Bank of Scotland, Santander,
Société Générale, State Street, Sumitomo Mitsui FG, UBS, Unicredit Group, and Wells Fargo. Fin. Stability Board, Policy measures to address systemically important financial institutions (Nov. 4, 2011), available at
http://www.financialstabilityboard.org/publications/r_111104bb.pdf.
17. Financial Stability Board, 2013 update of group of global systematically important banks (G-SIBs) (Nov. 11, 2013), available at
http://www.financialstabilityboard.org/wp-content/uploads/r_131111.pdf. The four banks from the 2011 list that were not included in 2013 were Banque Populaire CdE,
Commerzbank, Dexia, and Lloyds Banking Group. The four banks included on the 2013 list but not the 2011 list were BBVA, Group BPCE, Industrial and Commercial Bank of China Limited, and Standard Chartered.
18. Financial Stablity Board, 2014 update of list of global systematically important banks (G-SIBs) (Nov. 6, 2014), available at http://www.financialstabilityboard.org/wp-
content/uploads/r_141106b.pdf. The additional bank is the Agricultural Bank of China.
19. See Fin. Stability Board, Policy measures to address systemically important financial institutions (Nov. 4, 2011), available at
http://www.financialstabilityboard.org/publications/r_111104bb.pdf.
20. Bd. of Governors of Fed. Res. Sys., Risk-based capital guidelines: Implementation of capital requirements for global systemically important bank holding companies, 12 CFR Part 217; 79 Fed. Reg. 243 (Dec. 18, 2014), 75473.
21. Proposed rule, Fed. Reg. 75479.
22. Proposed rule, Fed. Reg. 75474.
23. Proposed rule, Fed. Reg. 75475.
24. This is consistent with the Federal Reserve Staff’s internal memo on the G-SIB capital surcharge.
25. Table 2 surcharge estimates, multiplied by Basel III RWA as indicated on Q3 2014 FFIEC 101 Schedule A item 60.
26. Federal Reserve Board, Calibrating the GSBI Surcharge (Jul. 20, 2015), available at http://www.federalreserve.gov/aboutthefed/boardmeetings/gsib-methodology-paper- 20150720.pdf; see also Final rule: Implementation of risk-based capital surcharges for global systemically important bank holding companies, 80 Fed. Reg. 157 (Aug. 14, 2015) (codified as 12 CFR Parts 208 and 217).
27. See generally Michael Crouhy, Dan Galai, and Robert Mark, The use of internal
models: Comparison of the new Basel credit proposals with available internal models for credit risk, in Capital Adequacy beyond Basel (Hal Scott, ed.) (New York: Oxford University Press, 2005), 197ff.
28. Id.
29. Id.
30. Press Release, Basel Comm. on Banking Supervision, Group of Governors and Heads of Supervision announces higher global minimum capital standards (Sep. 12, 2010), available at http://www.bis.org/press/p100912.pdf.
31. 12 USC §5371 (2012).
32. Id.
33. Id.
34. The proposed rule would apply to US BHCs with at least $700 billion in total consolidated assets or at least $10 trillion in assets under custody. See Regulatory capital rules: Regulatory capital, enhanced supplementary leverage ratio standards for certain bank holding companies and their subsidiary insured depository institutions, 78 Fed. Reg. 51,101, 51,104 (Aug. 20, 2013).
35. See Andrew Haldane, Constraining discretion in bank regulation, Speech given at the Federal Reserve Bank of Atlanta 1, 3 (Apr. 9, 2013), available at
http://www.bankofengland.co.uk/publications/Documents/speeches/2013/speech657.pdf.
36. Id.
37. Testimony before the S. Comm. on Banking, Housing & Urban Affairs, 112th Cong. 18 (Jul. 21, 2011) (statement of Hal S. Scott, Director, Comm. on Capital Mkts. Reg.), available at http://www.capmktsreg.org/pdfs/2011.07.21_Senate_Statement.pdf.
38. Press Release, Morgan Stanley, Oliver Wyman wholesale and investment banking outlook: Liquidity conundrum: Shifting risks, what it means (Mar. 19, 2015).
39. Id.; see also Press Release, Basel Comm. on Banking Supervision, Basel II capital framework enhancements announced by the Basel Committee (Jul. 13, 2009), available at http://www.bis.org/press/p090713.htm.
40. Basel Comm. on Banking Supervision, Basel III: A global regulatory framework for more resilient banks and banking systems 1 (Jun. 2011), available at
http://www.bis.org/publ/bcbs189.pdf.
41. Id. at 21–27.
42. Basel Comm. on Banking Supervision, Principles for sound stress testing practices and supervision (May 2009), available at http://www.bis.org/publ/bcbs147.pdf.
43. Id.
44. See Press Release, Bd. of Governors of the Fed. Res. Sys. (Nov. 22, 2011), available at http://www.federalreserve.gov/newsevents/press/bcreg/20111122a.htm.
45. Id.
46. Bd. of Governors of the Fed. Res. Sys., Comprehensive capital analysis and review 2012: Methodology and results for stress scenario projections 2 (Mar. 13, 2012).
47. Id.
48. US Department of Treasury, 2012 Office of Financial Research, Annual Report to
Congress (Jul. 20, 2012), available at
http://www.treasury.gov/initiatives/wsr/ofr/Pages/2012annual_rpt.aspx.
49. See, for example, Martin Wolf, Basel: The mouse that did not roar, Fin. Times (Sep. 14, 2010), available at http://www.ft.com/cms/s/0/966b5e88-c034-11df-b77d-
00144feab49a.html.
50. See Press Release, Bd. of Governors of the Fed. Res. Sys. (Apr. 8, 2014), available at http://www.federalreserve.gov/newsevents/press/bcreg/20140408a.htm.
51. Hal S. Scott, Reducing systemic risk through the reform of capital regulation, 13 J. Int’l Econ. L.763, 773 (2010).
52. Source: Bloomberg and Company 10Ks; as of 12/31/07. Tier I common equity is
calculated by adding Accumulated Other Comprehensive Income to Tangible Common Equity. Each capital ratio is calculated based on Basel I risk-weights.
53. 17 CFR §§200.30–3, 240.3a4–2 to -6, 240.3a5–1, 240.3b-17 to -18, 240.15a-7 to -9 (2004).
54. IMF, Global Financial Stability Report (Apr. 2009), available at www.imf.org/external/pubs/ft/gfsr/2009/01/pdf/text.pdf.
55. Laura Chiaramonte and Barbara Casu, Are CDS spreads a good proxy of bank risk?
Evidence from the financial crisis 30 (2011), available at
http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1666793.
56. Terminating Bailouts for Taxpayer Fairness Act of 2013, SLC, 113th Cong. §2 (2013).
57. Id.
58. Id.
59. Id.
60. H.R. 3189, the Federal Reserve Oversight Reform and Modernization (FORM) Act.
61. In the United States, implementation of the Basel III framework must also be
compliant with the floors established under Section 171 of the Dodd–Frank Act (the
“Collins Amendment”). The Collins Amendment requires that the minimum leverage requirements and capital requirements for nonbank financial companies regulated by the Fed as SIFIs must not be less than the requirements that apply to insured
depository institutions under the Federal Deposit Insurance Act and must also not be less than the requirements in effect for insured depository institutions when Dodd–
Frank was enacted in 2010, which were the Basel I requirements. On December 18, 2014, the Insurance Capital Standards Clarification Act of 2014 was enacted, clarifying that a regulated insurance company would be exempt from these requirements “to the extent such person acts in its capacity as a regulated insurance entity.” See Public Law
113–279 [S. 2270], available at http://www.gpo.gov/fdsys/pkg/PLAW- 113publ279/pdf/PLAW-113publ279.pdf
62. David Miles, Jing Yang, and Gilberto Marcheggiano, Bank of England, Optimal bank capital (Discussion Paper 31, Apr. 2011), available at
http://www.econstor.eu/obitstream/10419/50643/1/656641770.pdf; Brooke Masters and Patrick Jenkins, Bank researchers call for doubling equity safety net, Fin. Times (Jan. 27, 2011), available at http://www.ft.com/cms/s/0/1f4841ea-2a0b-11e0-997c- 00144feab49a.html#axzz1CNpz1rPk.
63. Neil Maclucas and Katharina Bart, UBS, Credit Suisse face tough new capital rules, Wall St. J. (Oct. 4, 2010), available at
http://online.wsj.com/article/SB10001424052748704631504575531222507779044.html 64. Klaus Wille, Swiss lawmakers approve curbing risks at UBS, Credit Suisse, Bloomberg
(Sep. 30, 2011), available at http://mobile.bloomberg.com/news/2011-09-30/swiss- lawmakers-approve-curbing-risks-at-ubs-credit-suisse.
65. Swiss Nat’l Bank, 2012 Financial Stability Report (Jun. 2012), available at
http://www.snb.ch/n/mmr/reference/stabrep_2012/source/stabrep_2012.en.pdf.
66. Andy Winkler and Douglas Holtz-Eakin, Regulatory reform and housing finance:
Putting the “cost” back in benefit–cost 1 (Oct. 25, 2012), available at
http://americanactionforum.org/research/regulatory-reform-and-housing-finance- putting-the-cost-back-in-benefit-cost
67. Inst. of Int’l Fin., The net cumulative economic impact of banking sector regulation:
Some new perspectives (Oct. 2010), available at http://www.iif.com/download.php?
id=/0eTxourA+A=; MAG, Bank for Int’l Settlements, Final Report: Assessing The macroeconomic impact of the transition to stronger capital and liquidity requirements (Dec. 2010), available at http://www.bis.org/publ/othp12.pdf; Paolo Angelini et al., Basel III: Long-term impact on economic performance and fluctuations (Bank of Int’l Settlements, Working Paper 338, Feb. 2011); Scott Roger and Jan Vlcek,
Macroeconomic costs of higher bank capital and liquidity requirements (Int’l Monetary Fund, Working Paper 11/103, May 2011), available at
http://www.imf.org/external/pubs/ft/wp/2011/wp11103.pdf; Patrick Slovik and Boris Cournède, Macroeconomic Impact of Basel III (Org. for Econ. Co-Operation and Dev., Econ. Dep’t Working Paper 844, 2011), available at
http://dx.doi.org/10.1787/5kghwnhkkjs8-en; US Government Accountability Office, Bank capital reforms: Initial effects of Basel III on capital, credit, and international competitiveness (Nov. 2014), available at http://www.gao.gov/assets/670/667112.pdf.
68. Phil Suttle, Inst. of Int’l Fin., The cumulative impact on the global economy of changes in the financial regulatory framework (Sep. 6, 2011), available at
http://www.iif.com/emr/resources+1359.php.
69. Fin. Stability Bd., Identifying the effects of regulatory reforms on emerging market and developing economies: A review of potential unintended consequences (Jun. 19, 2012), available at www.financialstabilityboard.org/publications/r_120619e.pdf. Input for this study was received from national authorities in 35 EMDEs that are members of the FSB or an FSB Regional Consultative Group. The FSB additionally caveats that
“[w]hile it is too early to be able to fully assess the materiality and persistence of the effects of regulatory reforms on EMDEs, it would be useful to monitor them on an ongoing basis as well as to share experiences and implementation lessons.” Id. at 4.
70. See Comm. on Capital Mkts. Regulation, Capital study report: Use of market discipline (2014), available at http://capmktsreg.org/app/uploads/2014/07/CCMR-Capital-
Study-Report-2014.pdf.
15 Liquidity Requirements
Liquidity is the second wing of regulatory reform, and one more aimed at preventing contagion than capital requirements. Minimum “private” liquidity requirements (as distinct from “public” liquidity supplied by the Fed) are supposed to assure banks’
uninterrupted holding of a pool of high-quality liquid assets that can be sold (or pledged as collateral) to accommodate a sudden surge of withdrawals by depositors and other short-term debt holders during a serious crisis involving contagion.1 In principle,
maintaining sufficient high-quality assets should help financial institutions to withstand periodic instability created by the dependency on short-term funds. However, liquidity requirements are curiously in conflict with the Fed’s monetary policy efforts, insofar that quantitative easing is intended to get financial institutions to hold riskier assets to raise interest rates, whereas liquidity rules require banks to hold assets with low rates of interest reflecting their liquidity.
Initially, liquidity requirements seem to represent a more promising regulatory approach to contagion than capital requirements, since contagion originates in and
propagates through runs that are fundamentally liquidity driven. Four primary objections to over reliance on private liquidity requirements should be considered.
First, like capital requirements, the liquidity proposals discussed below (with the
exception of redemption restrictions and liquidity requirements for money market funds discussed later in this part) apply only to depository institutions, for short banks. In modern financial panics, as in 2008, contagion spread beyond the traditional banking sector—a fundamental point that is made throughout this book.
Second, the stock of high-quality assets that banks can hold to meet private liquidity requirements is limited by nature. Basel’s proposal, for instance, would require banks to retain sufficient liquid assets to match net cash outflows over 30 days.2 However, it is quite possible that persistent disruption to short-term borrowing markets leading to
sustained investor outflows stretching over a longer period could eventually overrun even the strongest portfolio of liquid assets, making it difficult to liquidate even “liquid” assets and forcing financial institutions into liquidating long-term assets to meet incremental redemptions. Short-term creditors of a financial institution subject to such liquidity requirements would thus still have an incentive to exit sooner, while that portfolio was still intact, rather than later, after waves of outflow have exhausted it.
Third, holding assets suited to meeting the purposes of liquidity requirements entails costs to financial institutions and to the economy, since every dollar of capital allocated to low-yielding, liquid, short-term securities is unavailable to finance longer term lending to borrowers. This theoretically lowers the amount of new credit that financial institutions can create and raises the overall cost of capital to the real economy. Further, when
combined with the leverage requirement, banks will tend to hold only the minimum