Federal Deposit Insurance Corp. Board Director Jonathan McKernan said Wednesday he believes the FDIC has not properly justified its rationale for its July proposal implementing the Basel endgame standards, saying the proposal could give nonbanks a competitive edge, drawing deposits out of the highly regulated, insured banking system.
McKernan — who voted against the proposal when it was
"I don't think the solution is to pile on more prescriptive regulation or otherwise try to push responsible risk-taking out of the banking system," he said. "I think what we need to do is accept — and I mean truly accept — that bank failures, including large bank failures, are an inevitable result of a dynamic and innovative economy, and we should plan for those bank failures by focusing on strong capital requirements and an effective resolution framework as our best hope for ending this practiced habit we've seemed to develop for privatizing gains while socializing losses."
McKernan said a handful of Basel reforms lack rationale and are therefore hard to justify. Regulators' proposal to replace banks' own risk weighting models with a standardized approach effectively increases capital, which banks would otherwise lend out for generating returns.
He added that the Basel committee itself noted in its consultative documents that a standardized approach for calculating would result in the overcapitalization of banks with high fee revenue. He noted the international committee even proposed a fix for this issue and the consultative documents, but it then dropped that fix from the final standards without explanation, which he said leaves regulators unable to defend an important formula.
Historically, the adequacy and robustness of banks' market risk models are validated through back-testing — which compares the actual outcomes with model forecasts. While the current standards allow banks to use internal risk calculation models on an entity-wide basis, under the proposed Basel endgame standards a bank's trading desk may only use the internal models to calculate the market risk capital requirements once it passes a series of tests that analyze the accuracy of its internal models. Otherwise, the regulator-set standardized approaches must be used.
One important part of the Basel proposal — known as the Fundamental Review of the Trading Book — establishes an additional test for trading desks known as the Profit and Loss Attribution, or PLA, test. Banks would need supervisory approval of models at each individual trading desk and the PLA test would grade individual trading desks into one of three rating zones: green, amber or red — which McKernan referred to as a 'traffic light' approach.
A desk falling into the amber zone — suggesting a likelihood of discrepancies in their model — would be subject to an additional capital requirement for the desk called the PLA add-on, whereas desks in the red zone would be disqualified from using its internal models.
McKernan said he thinks the thresholds used in the PLA test lack justification.
"These quantitative thresholds under this traffic light approach really do matter in determining the market risk capital requirement," he said. "Given it's important, you might assume there's ample theory and data to back up the committee's calibration of those thresholds, but as you probably already guessed, there's precious little in the public domain as to how the committee came up with these thresholds."
He also weighed in on the ongoing debate between regulators and the bank industry over whether higher capital will push competition out of the banking system. While bank trade groups have argued higher capital makes banks less competitive against nonbanks, the FDIC Chairman Martin Gruenberg noted last month that rather than allowing the prospect of nonbank competition to discourage requiring banks to be adequately capitalized, he believes appropriately strong capital requirements for banks should be complemented by also applying stronger prudential oversight for nonbanks.
Gruenberg even went on to call on the Financial Stability Oversight Council to apply partial enhanced prudential standards and enhanced reporting requirements tailored to the risks posed by particular nonbanks like open-ended mutual funds, hedge funds and nonbank lenders.
McKernan argued Tuesday that he agrees nonbank regulation and banking system stability should not be a zero-sum game, and he just wants regulators to carefully consider and publicly justify their proposals.
"I don't think anyone's actually arguing for a race to the bottom," he said. "We should aim to foster a level playing field across market participants taking into account differences in risk profile associated with different funding and business models [and] I'm left struggling to see how we can work to harmonize requirements across banks and nonbanks when we — the bank regulators — have not offered a calibration rationale for capital requirements, and indeed some aspects of the endgame proposal arguably might even be contrary to the available evidence."
He points to the increasing dominance of Fannie Mae and Freddie Mac since bank capital was raised in the early 1980s as evidence of how unequal capital requirements provide nonbanks competitive edges. He said because the government-sponsored enterprises' capital requirements were left unchanged initially, they gained a competitive advantage and market share relative to banks in holding mortgage-related risks on their books.
"The natural incentive was for banks to take a mortgage out — a 50% risk weight back guarantee fee — to a GSE, and get back a GSE-guaranteed mortgage-backed security that had a 20% risk weight," he said. "This natural capital arbitrage drove rapid growth in the GSEs [whose] market share increased from 10% in the early 1980s to 25% by the end of that decade and 44% by the end of 2003, culminating in the bailouts of the GSEs in 2008."
He also expressed concerns about the bank regulators' recent proposal to make banks hold long-term debt. That proposal would require regional lenders and certain foreign banking organizations to issue long-term debt out of the top tier U.S. parent company and also out of the bank subsidiary. GSIBs, he noted, do not have to issue LTD out of their subsidiary level, though they do position some resources at the bank subsidiary through the internal issuance of debt by the bank subsidiary on a bespoke basis in dialogue with regulators. While he ultimately voted to advance the proposal, he has ongoing concerns that it could unintentionally calcify regional banks' current business models or incentivize them to pull more of their activities into the bank subsidiaries.
"Regional banks would have less flexibility than the U.S. Global systemically important banks to preposition resources throughout the banking organization," McKernan said. "That could suggest that regional banks could have less flexibility and perhaps more difficulties in developing resolution plans to preserve the franchise value of their nonbank businesses [and] has the unintended consequence of shielding the USGSIBs from competition with our regional banks."
Reflecting on the turmoil seen in a string of bank failures in March, McKernan questioned regulators' ultimate decision to invoke a systemic risk exception and forgo least-cost resolution to protect uninsured depositors at Silicon Valley and Signature banks. He argued the inability to resolve the banks in normal order proved bank regulatory reform efforts spearheaded by the Dodd-Frank Act had not adequately improved regulators' ability to resolve large banks. While he agreed that some targeted reforms are needed, he believed regulators should more clearly justify their calibration of each new standard and that public comments will opine on any lingering gaps in the existing proposals.
Regulators would be "more likely to get these proposals right — or at least to get them less wrong — if we hold ourselves accountable for giving reasons for where we ended up," McKernan said. "To the extent we've not done that, I hope commenters will let us know and also share views and how we should try to fix that gap, even if it means developing our own U.S. implementation that deviates from the Basel standards, in some respects."
