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04 August 2017

IMF: Back to the Future: The Nature of Regulatory Capital Requirements

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This paper compares the current regulatory capital requirements under the Dodd-Frank Act (DFA) and the 10-percent leverage ratio, as proposed by the US Treasury and the US House of Representatives' Financial CHOICE Act (FCA).

[...]  On June 8, 2017, the U.S. House of Representatives passed the Financial CHOICE Act (FCA), which was first put forward in 2016 by the House Financial Services Committee. According to the chairman of the committee, the FCA “replaces Dodd-Frank’s growth-strangling regulations on small banks and credit unions with reforms that expand access to capital so small businesses on Main Street can grow and create jobs.” The FCA is a comprehensive regulatory proposal that, in reality, would modify some elements of the DFA, leave certain DFA key elements untouched, and repeal some parts of it. A key proposal is the introduction of a regulatory “off-ramp”, which would provide substantial regulatory relief for so-called “qualifying bank holding companies” (discussed below). On June 12, 2017, the U.S. Treasury Department presented a report on recommendations for regulatory reforms for banks, which echoes many of the FCA’s proposals, such as an off-ramp conditional on capital levels, but also regulatory relief for small and medium-sized banks as well as other measures.

Both reports criticize the DFA’s complexity and regulatory burden, especially for small and community banks, and call for regulatory relief. As options, they propose for banks to choose between the DFA and a leaner regulatory regime if capital levels are sufficiently high. Specifically, banks with a leverage ratio of 10 percent or more would qualify to become “qualifying banking organizations” (QBOs), and to be exempted from most DFA and Basel III rules, including risk-based capital and liquidity standards; limits to concentration risk; counterparty risk standards, and any law that prevents banks from M&A or similar activities. Also, QBOs would be exempted from the application of Enhanced Prudential Standards (including mandatory supervisory and company-run stress tests; single counterparty credit limits; and minimum requirements on liabilities3) and the submission of living wills.
This paper undertakes three exercises to assess the QBO option. First, it estimates using balance sheet data which types of banks (by asset size) would qualify for the off-ramp under the FCA, and how much capital banks would need to add in order to qualify for the “off-ramp” regulation. Second, to surmise whether there could be a self-selection of more risk-prone banks in the off-ramp the paper analyzes the balance sheet characteristics of banks with a relatively small capital gap to the 10-percent leverage ratio.4 The paper also highlights the potential for regulatory arbitrage by banks and the associated moral hazard problem that arises due to the QBO option. A final section discusses policy considerations.
The paper shows that, in contrast to initial expectations, small banks (total assets below $3 billion) with capital gaps to the QBO threshold would tend not to opt for the “off-ramp.” Capital requirements for small banks are less demanding than those for SIFIs and, typically, smaller banks hold comparatively less risky assets—as indicated by the relatively lower RWA to total assets ratio (“RWA density”). This follows from a comparison of the capital requirement under DFA and the leverage ratio under FCA, conditional on a bank’s actual RWA density.5 For small banks, the density would have to be almost 120 percent to meet the off-ramp criterion. Due to their higher average RWA density, large banks (total assets of more than $3 billion) are closer to qualifying for the off-ramp, given current capital levels. In addition to the minimum risk-based Tier 1 capital requirement (6 percent) and the fully phased-in capital conservation buffer (CCB) of 2.5 percent, SIFIs are subject to a surcharge of up to 4.5 percent of RWA, bringing the Tier 1 capital requirement to 13.0 percent.6 For SIFIs to meet the off-ramp criterion, RWA density would need to exceed 77 percent.
This paper also provides a financial stability rationale for maintaining the DFA’s risk-based capital requirements. The analysis in this paper shows that, irrespective of balance sheet size, a bank is likely to use the option to be designated a QBO and engage in regulatory arbitrage, reducing the effective capital charge. This moral hazard problem would manifest itself through banks increasing the RWA imprint in their balance sheet through increased risk-taking, thereby qualifying for the “off-ramp” regulatory relief under which banks hold 10 percent leverage ratio while enjoying higher expected returns and lower regulatory costs. This would make the banks riskier and, due to smaller capital buffers, less resilient to adverse shocks. Although this moral hazard problem is present irrespective of bank size, large banks with riskier balance sheets (i.e., high RWA density) appear more likely to aim to become QBOs. This combination would make the largest banks subject to lower requirements than banks of other sizes, and the stated policy intention to give relief to small banks may not materilise.

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© International Monetary Fund

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