Part VII in Our Series on US Bank Capital Requirements

In this joint note, we explain how the U.S. methodology for assessing a capital surcharge on global systemically important banks (GSIBs) differs from international norms, overstates the risk presented by those firms, and puts them at a competitive disadvantage.  It also provides recommendations for how to rationalize the surcharge and thereby significantly expand the ability of the affected banks to expand credit availability and maintain liquidity in U.S. capital markets.

Our analysis suggests that implementing these adjustments would reduce GSIB surcharges by roughly one percentage point which would expand lending and market making capacity by over $1 trillion and boost economic growth by roughly $25 billion per year without sacrificing bank safety and soundness.

Background

The U.S. capital framework requires a GSIB to maintain capital above and beyond generally applicable minimum risk-based capital requirements.  The GSIB surcharge requirement reflects the Federal Reserve’s unilateral assessment of systemic risk as measured by the weighted sum of a select set of indicators, expressed as a systemic risk score.  The higher the score, the higher the applicable GSIB surcharge.

The applicable surcharge is calculated as the higher surcharge of two methods – “Method 1” is the standard adopted by the Basel Committee on Banking Supervision for identifying and setting the surcharge for GSIBs and depends on five sets of systemic indicators – size, interconnectedness, complexity, cross-jurisdictional activity, and substitutability. “Method 2” is a U.S. only creation that generally employs the Basel methodology but replaces the substitutability indicator with a short-term wholesale funding (“STWF”) indicator.^[1] During periods of stress, reliance on short-term wholesale funding might make firms more susceptible to runs that could potentially impact financial stability.

In practice, the Method 2 surcharge always equals or exceeds that of Method 1. It is one of several binding capital constraints for U.S. GSIBs that is calibrated at a higher level.

Method 2 Needs Two Revisions to Appropriately Reflect Changing Realities

In this post, we describe two well-known shortcomings of the Method 2 GSIB score and suggest two adjustments that would improve Method 2’s measurement of systemic risk. Two inherent design shortcomings prevent Method 2 from appropriately reflecting changing realities.^[2]  First, Method 2 assumes the aggregate global systemic indicators are fixed for all time.  This assumption erroneously causes an increase in Method 2 scores for reasons unrelated to systemic risk, such as the growth in the global economy over time and the expansion of the Federal Reserve’s balance sheet.^[3]  The BCBS published aggregate global size indicator has grown nearly 50% from end-2013 (€66.31 trillion) to end-2021 (€98.48 trillion).  The fixed for all time nature of the Method 2 score implies that even if a U.S. GSIB had kept its market share constant during 2013-2021, its size indicator score under Method 2 would have increased by 50% while it would have been unchanged under Method 1.  Clearly, Method 2 scores inappropriately penalize a bank for growing along with the rest of the economy.  Growth consistent with the overall level of economic growth bears no relation to systemic risk and should not be counted as such.  Accordingly, Method 2 scores should be re-calibrated to adjust for the overall amount of economic growth that has occurred since the rule was finalized in 2015.

Second, the importance of the U.S. specific STWF factor in Method 2 scores has increased over time, counter to the Federal Reserve’s stated intent that each of the five factors mentioned above account for 20 percent of the Method 2 score.^[4]  In addition, Method 2 implicitly assumes global banks use STWF to fund illiquid assets which “can leave firms vulnerable to runs that undermine financial stability.”^[5]  However, a recent Federal Reserve study has shown that, over the past decade, “[g]lobal banks mainly use such funding to finance liquid, near risk-free arbitrage positions”.  These activities are core to support U.S. capital markets and economic growth which benefits both businesses, government, and consumers.  The results suggest that STWF actually poses low risk to financial stability and consequently that the STWF score significantly overstates systemic risk.^[6]  Accordingly, the STWF factor of the Method 2 score should be re-calibrated to ensure that it reflects only 20 percent of the overall score as originally intended by the Federal Reserve.

Recently, the Federal Reserve issued a proposal that would modify the GSIB surcharge in the U.S.  However, the Federal Reserve’s GSIB surcharge proposal does not address either of these two shortcomings.  Below, we demonstrate the impact of addressing these two shortcomings.

Adjustments to Method 2

In Table 1, we quantify the projected effects on Method 2 scores and surcharges of (1) accounting for economic growth and (2) reverting the weight of the short-term wholesale funding component to 20 percent. In total, taking into account both the economic growth adjustment and the recalibration of the STWF weight to 20 percent, the average GSIB surcharge would be reduced by 90 basis points.

First, we recalibrate the GSIB scores to account for economic growth.  Using 2015—the year when the fixed coefficients for score calculations were published—as our baseline, we measured the nominal GDP growth up to the recent four-quarter average and found a 44.4 percent increase. Consequently, we scaled the coefficients for size, interconnectedness, complexity, and cross-jurisdictional activity by a factor of 1.44. This recalibration led to a decrease in the aggregate GSIB scores by nearly 1000 points. Thus, the average surcharge was reduced by 60 basis points, bringing it down from 2.8 percent to 2.2 percent.

Table 1:  Proposed Adjustments to the GSIB Surcharge

Second, the weight of the short-term wholesale funding component in the overall score would increase to about 35 percent after adjusting the other coefficients for economic growth. As per the preamble of the GSIB final rule, this component is intended to have a 20 percent weight. To return it to that level, the “fixed conversion factor” needs to be recalibrated from 175 to roughly 80. This adjustment would further decrease the average GSIB surcharge by 30 basis points.

Economic Impact

As shown in the table above, implementing these two adjustments would reduce the average GSIB surcharge by 0.9 percentage points (90 basis points).  Because capital is the most expensive form of finance, reducing the amount of required capital lowers the cost of bank borrowing and boosts economic growth.  One data-based study conducted by the Bank of England concluded that a one percentage point decrease in required capital would decrease borrowing costs by 10 basis points and boost GDP by roughly $50 billion per year.  This study, however, considers the entire banking sector.  Because the GSIB surcharge only applies to U.S. GSIBs, the impact on economic growth must be adjusted for their share – roughly 50 percent – of the total banking sector.  As a result, this study suggests that reducing GSIB surcharges by 90 basis points would result in additional GDP of roughly $25 billion per year.

Another way of assessing the impact of reducing the GSIB surcharge on economic activity is to estimate the additional lending that could be supported by reducing the GSIB surcharge by 0.9 percent.  If U.S. GSIBs were held to a lower level of required capital, they would be able to grow their lending until the growth in lending resulted in a new capital ratio that matched the new and lower requirement.  Today, U.S. GSIBs maintain a capital ratio of 12.6 percent on average across all U.S. GSIBs.  Reducing their capital ratio by 0.9 percentage points to 11.7 percent would allow U.S. GSIBs to collectively grow their lending and market making activities by roughly an additional $1.1 trillion.  This additional capacity for banks to intermediate would directly benefit economic growth as businesses, households and communities would put those additional resources to work in the real economy.

Finally, it is important not to lose sight of the broader landscape with respect to large bank capital requirements.  Recently, the prudential agencies issued a “Basel III Endgame” proposal that would raise capital requirements for large banks by 19 percent.  Against this backdrop of a potential sizeable increase in capital, these adjustments would help to offset the negative economic impacts of other changes to large bank capital requirements.

Conclusion

The Method 2 GSIB surcharge implemented in the U.S. has two well-recognized flaws.  First, unlike the Basel GSIB surcharge (Method 1), Method 2 does not adjust for economic growth.  Consequently, as the economy grows, the U.S. GSIB surcharge increases, even without a corresponding increase in systemic risk.  Second, the importance of the STWF factor exceeds the 20 percent weighting intended by the Federal Reserve Board. We propose two simple and transparent adjustments to the Method 2 GSIB surcharge to address these issues. The adjustments would right-size the GSIB surcharge, leading to about a one percentage point decline in required capital. Such an adjustment would free up capital, reduce borrowing costs, add over one trillion in additional lending and market making capacity, and increase GDP by approximately $25 billion annually.  These adjustments to the GSIB surcharge are long overdue and would go a long way toward improving the large bank capital framework while also supporting the U.S. economy.

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Authors

• Guowei Zhang is Managing Director and Head of Capital Policy for SIFMA.
• Sean Campbell is Chief Economist and Head of Policy Research for the Financial Services Forum.
• Francisco Covas is Executive Vice President and Head of Research for the Bank Policy Institute.

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Footnotes

^[1] Method 1 calculates each systematic indicator score based on the ratio of that amount of that systemic indicator to the aggregate global indicator amount of that systemic indicator of that year.  Whereas for purpose Method 2, the aggregate global indicators amounts are fixed at the average of 2012-2013 amounts.

^[2] Method 2 has a set of other drawbacks that need to be addressed as we highlighted previously. https://www.sifma.org/resources/submissions/guidance-for-resolution-plan-submissions-of-certain-fbos/

^[3] https://bpi.com/gsib-method-2-fixed-coefficients-must-be-adjusted-for-economic-growth/

^[4]   In the preamble to the final rule, the Federal Reserve explained: “The conversion factor was intended to weight the short-term wholesale funding amount such that the short-term wholesale funding score receives an equal weight as the other systemic indicators within method 2 (i.e., 20 percent)…” 80 Fed. Reg. at 49,100-101.

^[5] https://www.govinfo.gov/content/pkg/FR-2015-08-14/pdf/2015-18702.pdf

^[6] https://fsforum.com/news/changing-realities-and-financial-regulation-the-changing-nature-of-short-term-wholesale-funding

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