FRB Vice Chair for Supervision Addresses Bank Capital Risks

In remarks before the American Enterprise Institute, Federal Reserve Board ("FRB") Vice Chair for Supervision Michael S. Barr outlined the elements of the board's "holistic" review of capital standards, and emphasized the importance of sufficient bank capital with respect to financial stability.

Among other areas, Mr. Barr addressed the following topics:

• Bank Capital and the Nonbank Sector. Mr. Barr warned of the rise of nonbank financial institutions' involvement in loans and other credit vehicles, which he said poses a significant threat to financial stability. He said nonbank lenders, including money market funds, insurance companies, the GSEs and hedge funds fund approximately 60 percent of the credit in the U.S. economy, but they (i) are not subject to the same regulations as traditional banks and (ii) typically receive funding that is more prone to runs, adding to the risk of significant disruption to the banking system. Mr. Barr argued that the FRB should "monitor the migration of activities from banks to the nonbank sector carefully," and should not lower bank capital requirements in a "race to the bottom."

• Calibration of Bank Capital Requirements. Mr. Barr emphasized that the right level of bank capital is "sufficient to enable [a] bank to absorb unexpected losses and continue operations through severely stressful but plausible events." He noted that while he doubts regulators or bank managers know the optimal level of bank capital, he is approaching the question with a "humble and skeptical view." Mr. Barr also noted that current U.S. bank capital requirements are on the low end of the range of the optimal capital levels determined by empirical and theoretical research.

• Risk-Based Requirements and Leverage Standards. Mr. Barr noted that risk-based bank capital requirements and leverage standards are two elements of the U.S. capital rules that are currently under review by the FRB. He emphasized that risk-based capital requirements are premised "on the fact that a firm is likely to experience higher losses from its riskier activities; thus, sizing capital requirements based on risk will better estimate a firm's capital needs so that it internalizes the risks of its activities." Mr. Barr said the last set of Basel III adjustments are being considered in the United States, and that he is working closely with his counterparts at the FDIC and OCC on the U.S. version of the final Basel III reforms. He argued that any rule changes that might be proposed in capital standards "would be deliberate, adopted through the notice and comment process so that we have the benefit of public perspectives, and implemented with appropriate transition periods to achieve the long-term goal of improving the capital regulation." Mr. Barr also noted that the FRB was examining empirical evidence and determining whether adjustments to the leverage ratio might be warranted as a number of market participants have indicated that "the leverage requirement for large banks is overly binding and may contribute to lower liquidity in Treasury markets, especially in stressed scenarios."

• Stress-Testing. Mr. Barr emphasized the importance of the FRB's stress-testing as a more dynamic regulatory feature when compared to the capital rules. He argued that stress tests could potentially counter actions taken by banks to achieve the best treatment under the U.S. capital rules, and can ultimately "serve as a check on excessive bank risk-taking." Mr. Barr argued that it is important that stress tests critically examine banks to "uncover hidden risks that could become manifest under certain scenarios." Mr. Barr noted that the FRB is currently reviewing whether supervisory stress tests used to establish the capital requirements for large banks are sufficiently reflective of the wide range of market risks and the interconnectedness of financial markets. Moreover, the FRB is "considering the potential for stress testing to be a tool to explore different sources of financial stress and uncover channels for contagion that lead to unanticipated consequences." Mr. Barr also emphasized that banks should continue to develop and run their own stress tests so that they can adapt to changes in the risk environment.

• Long-Term Debt Requirements. Mr. Barr noted that unlike regulatory capital, long-term debt becomes relevant and takes on greater importance once a firm has entered bankruptcy or resolution. While long-term debt requirements have historically been applies to global systemically important banks ("G-SIBS"), Mr. Barr said that the FRB and FDIC are currently determining whether the costs of a resolution of a non-GSIB also justify the imposition of long-term debt requirements on such firms.