The Federal Reserve must think twice about new capital buffers

The Federal Reserve must think twice about new capital buffers
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Basel III bank capital regulations were created in response to the 2008 financial crisis and prevent the failure of systemically important financial institutions. Basel III includes a discretionary countercyclical capital buffer that can be “fine tuned” by bank regulators. The countercyclical capital buffer has not been used in the United States, but the Federal Reserve is considering activating it. Proponents of the countercyclical capital buffer presume that it possesses near mystical power to control bank lending, a claim that lacks empirical support and belies common sense.

For believers, the countercyclical capital buffer is like a volume knob that controls bank lending. Turn the knob up and banks will slow lending. Turn the knob down, and banks will roll out new loans. The problem is that reality is not so simple. The countercyclical capital buffer applies to the largest institutions. The Federal Reserve can set the countercyclical capital buffer anywhere between 0 percent and 2.5 percent. The theory is that, by varying the countercyclical capital buffer rate, the Federal Reserve can tame the business cycle by controlling bank loan growth.

A countercyclical capital buffer of 0 percent is presumed to create incentives for banks to aggressively ramp up loan growth, while a countercyclical capital buffer of 2.5 percent is supposed to dampen bank lending. A lower countercyclical capital buffer takes immediate effect, while countercyclical capital buffer increases take hold 12 months after the announcement. There is scant evidence that supports the claim that changes in the countercyclical capital buffer will control bank lending.

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In fact, the story defies common sense. Before the Federal Reserve takes action, it is useful to debunk the myth that there are palliative economic benefits to be gained from activating the countercyclical capital buffer. Pretend for a moment that you are a banker, and the economy is heading into recession. The loan delinquencies of your bank are rising, which requires an increase in provisions for bank loan and lease loss expenses. Bank profits depend on the profitability of your customers, and the outlook for the businesses of your customers is looking grim.

Now, suppose the Federal Reserve announces a countercyclical capital buffer cut immediately to head off a recession. The countercyclical capital buffer cut frees up bank capital. If you were a banker, would you use the “capital surplus” to increase bank loans given the uncertain outlook, or would you keep the surplus capital to safeguard your bank? The impact of dour banker expectations will overwhelm whatever slight nudge the countercyclical capital buffer cut may give to bank lending, because bigger loans just mean bigger losses when customers default.

Consider the policy case for an increase in the countercyclical capital buffer. Timing is a big issue. When was the last time the Federal Reserve spotted a lending bubble a year before it peaked? If you were a banker, and the Federal Reserve increased the countercyclical capital buffer, would you cut lending while your customers are profitable and need new loans? If there is money to be made, the response of bankers is best described by the immortal words of former Citigroup chairman Charles Prince, “As long as the music is playing, you have to get up and dance.”

Now abandon common sense and consider the “hard” economic analysis purporting to legitimize the countercyclical capital buffer. Ironically, the 2012 testimony of the Federal Reserve on Basel III argues that the sizeable increase in bank capital requirements under Basel III would have very little impact on bank lending. To support its conclusion, the Federal Reserve cites a 2010 study by the Basel Committee on Banking Supervision that concluded that Basel III promised lots of benefits and very few costs.

However, if the governors of the Federal Reserve believed that higher bank capital requirements would not stifle bank lending in 2012, how can they believe today that a larger countercyclical capital buffer will tamper bank lending? The 2012 testimony asserts that modest changes in bank capital requirements have little or no impact on bank lending behavior.

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In truth, the costs and benefits of Basel III were never actually tabulated. The conclusions in the 2010 study were not based on analysis of any federal data. At that time, I was chairman of the Basel Committee on Banking Supervision Research Task Force and was part of the group assigned to draft the paper. The group never met. A month or so after the committee convened, a fully drafted paper appeared by email, but I refused to sign on. The study cherry picked theories and used simulations run by the Bank of England using a “black box” macroeconomic model that no one on the outside could analyze. It was a ruse needed to placate the politicians who demanded a cost benefit analysis of Basel III.

By far the most powerful forces driving lending behavior are banker expectations. If the economic outlook is dim, bankers will be cautious, and lowering the countercyclical capital buffer is unlikely to have a measurable impact on lending. When the outlook is rosy, there is money to be made, and bankers will dance regardless of how the countercyclical capital buffer is set. The Federal Reserve must keep this in mind.

Paul Kupiec is a resident scholar at the American Enterprise Institute in Washington. He served as the director of the Center for Financial Research at the Federal Deposit Insurance Corporation and is the former chairman of the Research Task Force of the Basel Committee on Banking Supervision.