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In deliberations over countercyclical capital, a push to enable cuts

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In deliberations over countercyclical capital, a push to enable cuts

As regulators revisit the financial stability framework a decade after the crisis, the countercyclical capital buffer has drawn intense interest at the highest levels.

Figures such as Federal Reserve Governor Lael Brainard have come out in support of activating the tool, which can be used to force banks to add a temporary, defensive layer of capital when risks are elevated. In a speech in March, Fed Vice Chairman for Supervision Randal Quarles said that a CCyB — and the power to dial it up and down — could provide flexibility "to react more quickly to economic, financial, or even geopolitical shocks."

The Fed heavyweights represent two distinct camps on the issue, with Brainard taking the more conventional view that the CCyB should come into play because of a buildup of financial vulnerabilities. Quarles, on the other hand, has argued that risks are in a normal range and that the U.S. has high "through-the-cycle" capital requirements. He has pointed to the framework in the U.K., where a CCyB equal to 1% of risk-weighted assets applies in a neutral environment. "To avoid having this be a significant increase to already very high levels of capital, the [Financial Policy Committee] undertook a one-time adjustment to its other capital buffers in order to offset part of this increase," Quarles said in March, referring to the British regulatory body.

In a Sept. 5 speech, Quarles proposed that the implementation of a CCyB for use in standard risk conditions could be counterbalanced with the elimination of the requirement that banks pre-fund capital distributions under their stress tests.

Under either approach, turning on a CCyB faces high hurdles in the U.S., analysts say, with banks opposed to tougher capital standards. Both Quarles and Fed Chairman Jerome Powell have repeatedly said that current capital levels are about right, and any move that would pave the way to lower capital requirements is likely to encounter stiff opposition as a backdoor softening of the regulatory regime.

Still, regulators' ongoing interest in the tool has been clear. Speaking after the Fed's most recent policy meeting at the end of July, Powell elaborated on the central bank's deliberations.

"We rely on through-the-cycle, always on, high capital and liquidity requirements," he said. "The idea of putting [a CCyB] in place so you can cut it, that's something some other jurisdictions have done, and it's worth considering."

"One point of it is that you can cut when there's a downturn and therefore give the banks more room," Powell added.

Some big banks have welcomed remarks like those. Speaking with reporters about JPMorgan Chase & Co.'s second-quarter earnings, CFO Jennifer Piepszak said Quarles' views on the CCyB "made a lot of sense. We can appreciate that it is effectively turned on but is not effective in terms of being levered at a moment when we may need it."

But Quarles pushed back against the notion that a bidirectional CCyB would amount to a "stealth" cut to capital levels in his Sept. 5 speech. "Though I have focused on the ability to reduce the CCyB in times of stress, I also would stand ready to increase the CCyB above the new baseline when it was appropriate to do so," he said.

Miguel Faria e Castro, an economist at the Federal Reserve Bank of St. Louis, found that a CCyB could be a powerful instrument for heading off financial panics and moderating their intensity in a recent research paper. Using a model calibrated to conditions in the run-up to the financial crisis a decade ago, Faria e Castro estimated that boosting capital requirements during leverage expansions could lessen the probability of crises by almost two-thirds.

Faria e Castro also estimated that lowering requirements from standard levels during a crisis could substantially cushion hits to economic activity by reducing the need for fire sales, inhibiting vicious feedback loops, and supporting consumption by borrowers. But combining precautionary increases with reductions once crises set in produced the best outcomes in his simulations, with most of the gains coming from the increases.

During a credit boom or asset bubble, raising capital requirements would be "the most effective thing in terms of preventing a crisis," Faria e Castro said in an interview.

Further, cutting capital requirements in the heat of a systemwide panic could intensify uncertainties about banks' health in ways that could magnify crises and are difficult to model. "There's a more subtle mechanism through which these things can operate. There's the signaling mechanism," Faria e Castro said. A strict stance by regulators might "inspire confidence."

Regulators in England did lower the country's CCyB when signs of a risk pullback emerged after the 2016 Brexit referendum, subsequently raising it to the neutral level of 1%. The maneuver has not been tested during a downturn, however.

Adam Gilbert, a partner in PwC's financial services advisory practice, also sees obstacles to a CCyB reduction during a severe crisis. "That's a hard thing to do," he said in an interview. "What you're basically saying is, well, things are bad and we're going to lower these requirements. So, should that make us less comfortable with the strength of the capital in the system?"

Gilbert contrasted such a move with the original stress tests in 2009, which are widely credited with helping restore confidence in the financial system by providing a credible assessment of capital positions at the largest banks and their ability to add to them.

Despite the operational and political obstacles, regulators' interest in the CCyB might best explained by the flexibility it could provide, said Capital Alpha analyst Ian Katz.

"The Fed likes tools. And they don't like when they can't use tools," he said. "So I think Quarles is thinking, it might be nice to be able to use this at some point."