FDIC Vice Chairman Thomas Hoenig
The Leverage Ratio and Derivatives: Presented to the Exchequer Club of Washington, DC
Wednesday, September 16, 2015
Key Topics & Takeaways
- Capital framework: Hoenig affirmed that it is “too soon” to forget the lessons from the financial crisis, and that instituting strong capital requirements is a “competitive strength” for U.S. markets.
- Derivatives under the Leverage Ratio: Hoenig encouraged policymakers to resist calls to weaken the Basel III leverage ratio treatment of derivatives, saying that large amounts of economic exposure to derivatives “would vanish from the regulatory capital radar screen” if the rules are changed.
- Opaque Transactions: Hoenig concluded that the lessons of the crisis were “learned at great expense” and that weakening derivatives capital requirements would encourage larger volumes of “inter-linked and opaque” transactions.
- Thomas M. Hoenig, FDIC Vice Chairman
Thomas Hoenig, Vice Chairman of the Federal Deposit Insurance Corporation (FDIC), opened by recalling that September marks the seventh anniversary since Fannie Mae and Freddie Mac were put under conservatorship, Lehman Brothers went bankrupt, Washington Mutual failed, among other negative financial market events. As such, Hoenig reiterated that it is too soon to forget the lessons from the financial crisis, and expressed concern that regulators are taking calls to weaken the leverage ratio seriously. He affirmed his view that strong capital requirements are still a pillar of the post-crisis reform agenda.
Regulatory Capital Framework
Hoenig summarized the arguments against a strong capital framework, including that capital requirements are perceived to hinder economic growth. He countered by highlighting the benefits of capital requirements, such that it provides necessary funding for banks activities, reassures counterparties, gives banks financial flexibility, and allows them to provide intermediary services throughout the economic cycle. Hoenig argued that it is “critical that capital requirements are set properly.”
Hoenig explained that the Basel III Leverage Ratio provides a “simple” metric to determine capital adequacy. He claimed the Leverage Ratio is intended to discourage banks from relying on risk weighting, which has proven “entirely unsuccessful” because it assigned favorable risk weightings to assets that later incurred severe losses in the lead up to the financial crisis, such as residential mortgage backed securities.
Hoenig also summarized several differences between the capital and leverage levels of investment and commercial banks leading up to the financial crisis, and explained that commercial banks were less leveraged partly due to banking agencies’ leverage requirements. He concluded that robust capital standards and leverage restrictions are a “competitive strength” of the U.S. economy.
Leverage Ratio and Derivatives Clearing:
Hoenig noted several arguments for the special treatment of derivatives under the Basel III Leverage Ratio, but explained that the derivatives clearing mandate is limited (i.e. it does not apply to certain products or non-financial end users that are hedging risk), and that derivatives clearing has increased even without incentives provided by finalized margin requirements. He also rejected the notion that the clearing mandate should “weaken” prudential regulation to stimulate the derivatives business. Rather, he argued that the post-crisis reforms must continue to ensure capital markets activities are backed by “meaningful capital support.”
Hoenig noted there is an argument to exclude client initial margin from the denominator of the Leverage Ratio, because bank affiliated futures commission merchants (FCMs) act as an agent for their clients. However, he argued that certain assets are recorded on-balance sheet under U.S. GAAP rules for a reason.
In the context of clearing, Hoenig explained that clearing members receive and invest client margin, and typically guarantee performance of a client under contract, so “there is risk.” He also noted that FCMs could avoid capital charges if they wished to do so, by ensuring the contract appropriately reflects that they are acting solely as an agent and that the risk lies with the client, in which case they would not have to include the asset on their balance sheet.
Hoenig warned that changing the current treatment of derivatives under the Leverage Ratio would impact the treatment of all derivatives, and would essentially take the U.S. financial system back to the pre-crisis framework. He concluded that the lessons of the crisis were “learned at great expense” and that weakening derivatives capital requirements would encourage larger volumes of “inter-linked and opaque” transactions. In doing so, he claimed such changes would essentially abandon the post-crisis regulatory capital reforms.
Question & Answer
An audience member inquired whether the regulator was considering instituting contingent capital requirements. Hoenig responded that the international community, including the Financial Stability Board (FSB), is considering Total Loss Absorbing Capital (TLAC). When pressed further, he argued that debt capital requirements do not work in a crisis and that, in his view, equity is the best option.
Another member from the audience asked whether the Leverage Ratio constitutes, in his view, risk-based capital because it induces banks to hold riskier assets. Hoenig quipped that “if that were true, the industry would love the Leverage Ratio,” which he said is not the case. Hoenig explained that his priority is to ensure there is enough capital to enable bank executives and managers to decide how to allocate it in a crisis, rather than have regulators dictate which assets are risky and thus require higher capital buffers. He added that the Leverage Ratio gives supervisors, investors, and the public a simple indication of capital adequacy.
A participant asked Hoenig his views on the thresholds for systemically important financial institution (SIFI) designation. Hoenig explained that he is “not a fan” of thresholds since they are arbitrary and create unlevel playing fields. He explained that the FDIC and Financial Stability Oversight Council (FSOC) will work on this going forward, and he expects it will “change often.”
When asked to comment on the recent living will exercise, Hoenig replied that he will not speak to the current process. However the earlier process for big banks, he said, was a “tough task,” and posed several difficult questions, including where money would come from to provide liquidity in bankruptcy and how a bankruptcy would work across borders. He said the incentive in a crisis is for local regulators to ring-fence capital and assets to protect domestic markets.
The final question from the audience was whether regulatory relief was forthcoming. Hoenig agreed that the regulatory burden is too high for some commercial banks and explained that he has a proposal on the table to provide regulatory relief for banks with over $100 billion in assets that meet certain criteria, such as having no trading activities, no more than $3 billion in derivatives activities, and maintaining equity as 10 percent of total assets, among other things.
For additional information, the full speech can be viewed here.
,Blog Tags:,Blog Categories:,Blog TrackBack:,Blog Pingback:No,Hearing Summaries Issues:General,Hearing Summaries Agency:FDIC,Publish Year:2015