One way or another, the Fed's capital proposal isn't going to fly

Bloomberg News

I'm not too proud to admit when I'm wrong. A few weeks ago in these pages I wrote a column describing how the Fed's highly anticipated Basel III: Endgame capital proposal would end up larding up capital on the very banks that saw capital relief under the prior administration — this despite Federal Reserve Vice Chair of Supervision Michael Barr saying in a speech that the capital raise would primarily be levied against "the largest, most complex banks." 

I took that to mean banks over $100 billion, and further inferred that the banks above that threshold that would feel the most pain were the midsize tranche of banks that seemed so evidently undercapitalized in this spring's episode of failures. But in my defense, I said that because that would have made sense. 

When the proposal finally dropped last Thursday, it was immediately apparent that Barr meant what he said without my interpretive assistance. The proposal would in fact weigh heaviest on the global systemically important banks — the biggest of the big, and the banks already subject to the most stringent capital requirements. 

The proposal will do this by effectively ending the "advanced approaches" regime that allows banks to use their own internal risk models in place of the Fed's standardized model, instead replacing it with not one but two Fed-developed standardized models and obliging the biggest banks to hold the higher of the two. Why does the Fed need two standardized models? Great question.

But the net effect of all of this is that the biggest banks are going to have to hold something like 20% more capital and the other banks over $100 billion will have to hold about10% more capital. The rationale for this, as Barr explained, is that "the benefits of a robust financial system, as well as resilient financial institutions, outweigh the costs to economic activity that may result from additional capital." By that standard, anything that is less costly to the economy and the taxpayer than the 2008 Global Financial Crisis would be justified. 

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Whether that rationale and the agencies' diligence in justifying this proposal is adequate is a question that I suspect will ultimately be decided by a judge. But I'm not even sure it will make it that far. Of the six members of the Federal Reserve Board of Governors, the two governors nominated by Donald Trump — Christopher Waller and Michelle Bowman — voted against the proposal. Another two — Fed chair Jerome Powell and vice-chair-designate Philip Jefferson — expressed reservations about whether this was a good idea, but agreed to put forth the proposal anyway. 

Even Barr himself seemed open to the possibility that the final version of the proposal may be quite different from the version we saw for the first time the other day, extending the public comment period to 120 days and saying "all comments will be carefully considered" and that the agency "will be vigilant in working to avoid unintended consequences" that result from the rule. Just to get the rule finalized, it seems he's going to have to make some substantial concessions.

The Basel III: Endgame — once known as Basel IV because it had such broad significance on its own — has been in the works since the global financial crisis and thus vastly predates the failures of Silicon Valley Bank, et al. But for better or worse, whatever the Fed came up with in this proposal would inevitably be viewed as a policy response to the unpleasantness of this spring. But if there's one thing that we learned from the recent bank failures — and to a lesser extent during the COVID pandemic — it's that the biggest banks can weather any number of different macroeconomic storms, and indeed are a source of strength for the banking sector.

I have no doubt that the biggest banks will be able to adapt to these changes if finalized as proposed. But I also have no doubt that the biggest banks will not take these changes lying down — this rule will be litigated, and that's a playing field that now favors the banks far more than the regulators.

Between the skepticism of a significant portion of the Federal Reserve Board and the likelihood that this proposal, if adopted, will spur litigation, it seems like this proposal is not going to win the day. But then again, I've been wrong before.