Fed’s Reversal on Bank Capital Requirements Serves No Purpose

The case for that requirement is flawed. The purpose of holding capital, usually shareholders’ equity, is to absorb potential losses. But Treasurys and reserves are risk-free. With that capital requirement back in place, the Fed achieves nothing toward making the financial system safer while potentially raising headwinds to its other goal: stoking an economic recovery with easy credit conditions.

The Fed exempted Treasurys and reserves from capital requirements a year ago in the midst of the market turmoil triggered by the initial pandemic-related economic shutdown. The central bank didn’t want banks to avoid holding or trading Treasurys because of the capital requirement. The exemption also in theory freed up capital that banks could use to make loans to businesses and households.

The decision announced Friday means the exemption is now due to expire March 31. Banks wanted it to continue but ran into a buzz saw of opposition from progressive Democrats. “The banks’ requests for an extension of this relief appear to be an attempt to use the pandemic as an excuse to weaken one of the most important postcrisis regulatory reforms,” Sens. Sherrod Brown of Ohio and Elizabeth Warren of Massachusetts said earlier this month.

Banks have long had to meet capital standards, which became tougher after the financial crisis. The main standard is risk-weighted, meaning banks must hold more capital against a riskier asset, such as unsecured credit-card debt, than a safer one, like a residential mortgage.

But there remains the prospect that banks might boost their holdings of a particular asset because regulators deem it lower-risk when in fact it isn’t—such as mortgages in the run-up to the financial crisis. So as a backup, some banks must also meet another standard, the supplementary leverage ratio. This requires the biggest bank holding companies to hold a minimum of 5% capital against all assets, including Treasurys and reserves.

The case for this rule has always been weak. Short of some apocalyptic scenario, the U.S. isn’t going to default on its debt, and the Fed certainly isn’t going to default on reserves it can create at a keystroke.

And the case has become weaker in the past year. First, the government is issuing a lot of debt. Banks hold and trade that debt as part of their job of keeping markets functioning. Reimposing the capital requirement will make it costlier to do so. Banks could issue more shares, but they might instead just reduce their presence in the Treasury market, which could lead to upward pressure on yields and a less well-functioning market.

Second and even more problematic is the restored capital requirement for reserves. The Fed influences interest rates and credit conditions by purchasing bonds and making loans. It finances both by issuing reserves, essentially electronic money. Banks have no choice but to hold those reserves. They can use them to settle payments with each other or the Treasury but in aggregate, banks’ holdings of reserves must generally rise in line with whatever the Fed creates.

Reserves were much lower when the current rule was put in place in 2014. But since the start of the pandemic the Fed has bought trillions of dollars of Treasury and mortgage-backed securities to keep long-term interest rates down and markets functioning smoothly. As a result, banks’ reserves at the Fed have shot up by roughly $2 trillion. In theory, that would require banks to hold as much as $100 billion of capital.

At present, banks have enough capital, so none will fall below their required level when the exemption ends. But with reserves expected to keep growing rapidly, banks might end up having to limit their activity in some financial markets or even lend less. This outcome would obviously run counter to the Fed’s monetary-policy goals of keeping interest rates low and credit flowing to get the economy back to full employment.

The Fed says it will propose modifications of the leverage ratio to resolve the problem created by high reserves and Treasury debt. This a problem that shouldn’t have been allowed to arise in the first place.

Write to Greg Ip at [email protected]