Regulators are debating whether the Federal Reserve should pull a new tool out of its capital toolbox to protect against economic downturns. Banking experts are divided on whether the industry's existing stress tests already fulfill this need.
The countercyclical capital buffer, or CCyB, would require banks to build up larger capital buffers so that they can continue lending if the economy sours. Countries outside the U.S. have deployed the CCyB to try to lessen the blow of a future economic decline.
The CCyB would generally apply to banks with more than $250 billion in assets or $10 billion in foreign exposures on their balance sheet. The Fed has so far decided to set the CCyB at zero percent of risk-weighted assets. The Fed's 2016 framework for CCyB implementation said the Fed would increase the level gradually, up to a limit of 2.5% of risk-weighted assets.
The Fed has said it needs to see "meaningfully above normal" risks of future losses to implement the CCyB. Its most recent monetary policy report described financial risks as moderate.
But some industry observers think it is time for the Fed to activate the CCyB, citing rising corporate debt levels and increasingly stretched stock valuations as two examples of higher risks. The U.S. is "clearly moving toward the later stages of the economic cycle" and should implement adequate capital safeguards for banks, said Gregg Gelzinis, research associate at the Center for American Progress, a liberal think tank.
"In order to counter the boom-and-bust cycles, you have to lean against them," he said. "I think this is an important way to do that."
Others are not so sure, noting the Fed does not yet deem risks as worryingly high, partly due to the post-crisis regulatory framework requiring banks to hold onto more capital and improve their liquidity. Bill Nelson, chief economist at the industry group The Clearing House, wrote in a recent blog post that there is little evidence that the CCyB would be an effective guard against financial imbalances. The Basel Committee on Banking Supervision, he noted, wrote in its guidance on the CCyB that the broader economic effects of the tool are "not yet well understood."
"Increasing capital requirements by potentially tens of billions of dollars on large banks is a major step, and a step that one would hope the Federal Reserve would not take for benefits that are only possible and not well understood," Nelson wrote.
Other countries have turned to CCyB
Though their methods have varied, several jurisdictions have activated the CCyB including the U.K., Norway, Hong Kong, Lithuania and the Czech Republic. French officials have also considered activating the tool, as they see rising levels of private-sector debt.
There are some critical differences between the U.S. and other countries, said Karen Petrou, the co-founder of Federal Financial Analytics, an industry research firm. For one, she said, some countries rely "almost exclusively" on banks for their financing, whereas financial activity in the U.S. is much more reliant on nonbanks. In products where nonbanks play a heavy role, such as U.S. mortgage origination, the CCyB "would have no impact" other than to push more activity to nonbanks, she said.
Petrou said other countries have less strict criteria, so "markets aren't particularly spooked by" regulators deciding to turn to the CCyB.
But in the U.S., she said, the Fed could send an alarm signal to the markets by activating the tool — or even suggesting that financial risks are more than moderate.
"That complicates their use of this trigger a great deal more," she said.
Fed's stress tests also play countercyclical role
It is not clear whether the Fed's Board of Governors would support increasing the CCyB. Fed Governor Lael Brainard has said it "may become appropriate" to deploy the CCyB if risks continue to build. But she was on the dissenting end of a proposal from the Fed that would effectively reduce leverage requirements for the largest U.S. banks, splitting with Fed Chairman Jerome Powell and Randal Quarles, the Fed's vice chairman for supervision.
A handful of regional Fed presidents have highlighted the CCyB as a tool the Fed should consider, though they do not vote on the issue since they are not part of the Washington, D.C.-based Board of Governors. Boston Fed President Eric Rosengren said in a March 23 speech "an argument can be made" for raising the CCyB. Cleveland Fed President Loretta Mester and Kansas City Fed President Esther George have also brought up the tool as an option for the Fed in recent appearances.
At the same time, the Fed has another tool at its disposal to help banks prepare for future downturns: the annual stress tests large banks must undergo.
Through those stress tests, the Fed can ask banks to plan for tougher hypothetical downturns, effectively requiring them to build up more capital to protect against those scenarios. This year, for example, the severely adverse scenario asks companies to plan for a global recession, in which equity prices would fall by 65% and the U.S. unemployment rate would reach 10%.
Nelson, of The Clearing House, wrote that through those tougher stress tests, the Fed "has already ensured that the largest banks are capable of withstanding an unprecedented unwinding of imbalances" combined with a downturn deeper than the Great Recession.
But CAP's Gelzinis noted the Fed is proposing changes to the stress tests that would effectively reduce the amount of capital large banks need to hold onto for planned dividends. Plus, he said, one capital buffer "doesn't make the other pointless."
