The relationship between fiscal policy and lending is
tightly woven, as is the relationship Federal Reserve Gov. Michael Barr sees
between lending and building better communities. Speaking at the American
Bankers Association’s Annual Convention in Nashville, Barr painted a picture of
how a recent visit to a Native American community in Montana illustrated this
relationship for him as he opined on the Fed’s proposed rulemaking affecting
institutions that represent the nation’s largest source of capital.
Barr explained how critical reforms built into the Dodd-Frank
Act were designed to bolster the quantity and quality of capital within the
banking system and the projected beneficial impact for communities.
“I have spent considerable time throughout my career
thinking about the potential of the financial system to make a difference in
the lives of individuals and their communities,” Barr said. “Access to credit
and other financial services is key to families navigating the many challenges
they face and building a better future. The pursuit of this goal inspires many
of you in your jobs as well. But in order for the financial system to play this
role, it must be able to weather unexpected stress and continue to serve its
customers and communities. And this requires that banks have sufficient capital,
the subject of a proposal that the agencies recently put out for comment.”
Barr retread some topics he touched on during his speech in
New York the week prior, adding new insights and takeaways of particular note
to lenders. He described his view of how the initial wave of reforms reshaped
the financial landscape, evidenced by a remarkable transformation in the common
equity capital ratio of the largest banking organizations, which surged from
5.5 percent in 2009 to 12.4 percent by the end of 2022.
“When the initial reforms were put in place,” Barr
explained, “bank regulators acknowledged that these changes were a partial
measure and that there were further elements of the capital rule that needed
adjusting: less reliance on internal models for credit risk; operational risk
should be captured in a standardized way; and capital requirements did not
fully capture market risk. The agencies’ proposed rule
attempts to address these issues.”
In the wake of the Dodd-Frank reforms, the U.S. economy
experienced substantial growth, with the assets of the U.S. banking system
expanding from $12 trillion to $23 trillion, Barr noted. Profits within the
banking sector, which had plummeted dramatically during the global financial crisis,
rebounded and nearly approached historical averages.
As banks fortified their capital reserves, their
profitability surged, paralleled by an increase in their market valuation. This
newfound strength enabled banks to play a pivotal role in supporting the
economy, maintaining their prominent position in the global capital markets.
Positioning it as a means to continue to build on the
progress made through previous reforms, Barr broke down the goals of the proposed
rulemaking into three parts:
1.
Eliminate the use of banks’ internal models
for setting credit risk capital requirements: “Experience has shown that
the subjective nature of these internal models resulted in unwarranted
variability across banks when assessing exposures with similar risks,” he said.
“This variance weakened confidence, reduced transparency, and made it
challenging to compare capital adequacy across different banks. To rectify
this, the proposal suggests replacing internal models with a standardized and
transparent approach called the ‘expanded risk-based approach.’ This approach
remains sensitive to key drivers of credit risk while ensuring consistency
across banks. The proposal also includes adjustments relative to the
international Basel Capital Accord to ensure similar capital levels for key
credit portfolios across small and large banks, maintaining competitive equity
across the spectrum of credit providers.”
2.
Move large banks away from internal models
for operational risk capital requirements: Instead, Barr said banks should
be “favoring standardized measures based on a banking organization’s business
volume and historical operational losses. Research has indicated that higher
business volumes are associated with greater operational risk exposure, and
higher operational losses are indicative of increased future operational risk
exposure.”
3.
Create a market risk framework aimed at
comprehensively addressing lessons learned from the financial crisis: Barr said banks should be able to use their
own risk mitigation models when appropriate, “provided these models account for
tail risks and the illiquid nature of some trading exposures. The framework
also incorporates a standardized approach to market risk as a safeguard for
situations where banks’ internal models may not adequately capture risk,
ensuring greater resilience during stress periods.”