CRS Considers Policy Issues on Bank Capital Requirements

In a "Primer" on bank capital requirements, the Congressional Research Service ("CRS") reviewed the current capital framework and highlighted regulatory policy issues.

Capital Requirement Levels

CRS examined factors in determining the "optimal" level of capital requirements. CRS said that ideally capital requirements would be set at a level high enough to protect against the systemic risk of bank failures, but not so high that risk outweighs the societal cost of reduced credit intermediation. CRS raised questions as to whether capital requirements should be simpler, which it suggested could lead to lower compliance costs and greater resiliency during periods of economic uncertainty.

Leverage Ratios in Capital Requirement Trends

CRS stated that leverage ratios provide a "belt and suspenders" approach to capital regulations by protecting the U.S. financial system against the failure risk of an individual institution or larger asset portfolio. With regard to smaller banks, CRS stated that by implementing the Community Bank Leverage Ratio ("CBLR"), Congress opted for "simplicity over risk sensitivity." CRS recommended that Congress or the regulators consider for non-CBLR banks (i) lowering leverage ratios to make risk-based standards a binding requirement or (ii) raising risk-based requirements to return them to a binding requirement.

Current Expected Credit Loss ("CECL")

CRS examined the impact of the Financial Accounting Standards Board adoption of the CECL approach. According to CRS, the new accounting approach requires "banking organizations 'to recognize lifetime expected credit losses and to incorporate reasonable and supportable forecasts in developing the estimate of lifetime expected credits losses, while also maintaining the current requirement that banking organizations consider past events and current conditions.' " CRS stated that banking regulators acknowledged that CECL implementation will impact regulatory capital by increasing allowance levels while decreasing retained earnings.

Exposure to Crypto Currency

CRS highlighted that traditional commercial banks currently have minimal exposure to cryptocurrency assets, but that could change if regulators allow banks to expand operations into crypto-markets. CRS reviewed the Basel Committee on Banking Supervision's ("BCBS") second consultative document on the regulatory treatment of crypto, which provides another regulatory framework. CRS said that the second consultation accounted for changes to the market by, among other things, “refin[ing] the way crypto is classified and includ[ing] stabilization tests for certain stablecoins[.]” CRS raised concern that a large exposure to crypto could undermine a bank's safety and soundness and recommended that these concerns should be addressed with capital requirements and other regulatory measures, such as prohibiting banks from engaging in activities that may result in crypto exposures.

Basel III Standards

CRS reviewed the BCBS Basel III standards (issued in 2017) that were intended to reduce "excessive" variability of risk-weighted assets ("RWA") and help restore credibility in the calculation of RWAs. CRS considered the implications for larger banks and found that they could experience (i) greater divergence between implementation of the standards from the agreements under Basel III, which could complicate international collaboration, (ii) increased complexity of U.S. regulations or (iii) elimination of U.S. divergence, which could lead to lower or higher capital requirements.

Large Bank Issues

CRS also highlighted several efforts by regulators since the 2008 financial crisis intended to further enhance bank capital rules for large banks. These include:

• Countercyclical Capital Buffer ("CCYB") - CRS highlighted that the Bank for International Settlements' primary objective for CCYB was to prevent financial instability as a result of excess credit growth by imposing a requirement on banks to hold more capital during periods where credit growth is high. CRS recommended several options to policymakers seeking to reform CCYB, including (i) determining the base level of CCYB using a formula, such as the rate of credit growth or asset price appreciation or (ii) repealing the CCYB completely.
• Total Loss Absorbing Capacity ("TLAC") - CRS stated that if policymakers seek to extend TLAC requirements to cover a larger category of banks, they could consider (i) applying the requirement to any bank meeting a particular criterion, such as a Category II or III, or (ii) requiring banks seeking to merge to meet the already established TLAC requirements as a condition to any mergers over a certain threshold.
• Supplementary Leverage Ratio ("SLR") Relief - CRS noted that during the COVID-19 pandemic, banks that held their reserve balances with the FRB or held Treasury securities were provided exemptive relief from the SLR in response to a surge in banks holding safe assets. This exemption expired in March 2021. CRS cautioned that making the exemption permanent could (i) limit the role of safe assets as a "strictly risk-neutral" measure of capital adequacy and (ii) lower capital requirements for large banks, unless the SLR was raised as a direct response.