The Fed weighs capital requirements for banks: Would changes boost transparency?

The collapse of Silicon Valley Bank (SVB) earlier this year could bring major changes to capital requirements for large banks. Federal Reserve vice chairman for supervision Michael Barr put the banking industry on notice during a speech to the Bipartisan Policy Center in Washington DC this week.

Barr made the case for a handful of changes needed to boost transparency of banks’ balance sheets. While technically the Fed doesn’t regulate banks (other than the 12 Fed banks and 24 branches under them), it’s responsible for supervising large banks with assets of $100 billion or more.

Barr painted with broad strokes during his remarks but gave enough detail for us to predict what’s likely to become reality for the big boys like Chase and Wells Fargo (the capital requirements would only apply to $100B or bigger banks).

Time to put an end to ‘creative’ credit risk estimates

Perhaps the biggest change Barr championed – and one that could be easier said than done to accomplish – is putting an end to banks’ rose-colored credit risk estimates. It’s what allowed SVB to keep depositors on board until word spread quickly how badly the bank was overleveraged.

Barr proposes the Fed should “end the practice of relying on banks’ own individual estimates of their own risk and instead use a more transparent and consistent approach. Currently large banks use their own internal models to estimate certain types of credit risk.” All of which leaves depositors, investors and the market as a whole in the dark regarding a bank’s financial health.

The third Basel Accord Principles (finalized in 2017), which sets international standards for bank capital adequacy, stress testing, and liquidity requirements, also called for transparency in how banks measure risk. Barr stressed the need for U.S. banks to catch up to the most current Basel framework.

“Standardized credit risk approaches, meaning we apply the same requirements to each bank and not let each bank develop their own requirements” must be part of new Fed capital requirements, says Barr. “[B]anks tend to underestimate their credit risk because they have a strong incentive to lower their capital requirements.” 

What it means for businesses: Banks are liable to dole out fewer loans and limit their risk. Businesses with the best credit ratings seeking loans will do better than others.

Some banks won’t be able to make the cut

Barr and the Fed are proposing other requirements to boost transparency and make big banks all play by the same rules, such as:

• holding an extra 2 percentage points of capital (at least $2 more for every $100 of assets). “Most banks already have enough capital today to meet the [proposed] requirements,” says Barr. “For the banks that would need to build capital to meet the requirements … [most] would be able to build the requisite capital through retained earnings in less than two years, even while maintaining their dividends,” and
• a mandatory long-term debt requirement to backstop the Federal Deposit Insurance Corporation (FDIC). “[This measure would] provide the FDIC with additional options for restructuring, selling or winding down a failed bank.”