The financial shock surrounding the COVID-19 pandemic has prompted the Federal Reserve to temporarily loosen an important capital-to-asset ratio requirement for US banks. In so doing, it is walking away from a decade-long commitment to global financial reforms forged in the wake of the global economic meltdown of 2008–10. This breach, together with other recent US government actions, may signal a broader departure from the Trump administration’s general adherence in its first three years to international financial standards, an area in which it had not acted against the global rules-based order. The motives for such breaches are not compelling enough to offset the downsides for the global financial system and for the United States itself. The new Fed rule breaches the Basel III Accord On
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The financial shock surrounding the COVID-19 pandemic has prompted the Federal Reserve to temporarily loosen an important capital-to-asset ratio requirement for US banks. In so doing, it is walking away from a decade-long commitment to global financial reforms forged in the wake of the global economic meltdown of 2008–10.
This breach, together with other recent US government actions, may signal a broader departure from the Trump administration’s general adherence in its first three years to international financial standards, an area in which it had not acted against the global rules-based order. The motives for such breaches are not compelling enough to offset the downsides for the global financial system and for the United States itself.
The new Fed rule breaches the Basel III Accord
On April 1, the Federal Reserve announced a temporary change to a regulatory requirement on banks known as the supplementary leverage ratio (or simply the leverage ratio). The leverage ratio, calculated as regulatory capital (or own funds) divided by unweighted assets, supplements the more refined ratios of capital to risk-weighted assets, which are the mainstay of bank capital regulation. While a crude measure of capital strength, the leverage ratio is an apt response to the banks’ incentives to underestimate risk-weights; it acts as a simple sanity check, thus the epithet “supplementary.”
The new change, which the Fed adopted unanimously, exempts banks’ holdings of US sovereign debt (Treasuries) and deposits at the Fed from the assets total in the ratio calculation until end-March 2021. This exemption reduces the denominator, making it easier for banks to meet their minimum-ratio requirements during that period. By exempting sovereign exposures, the rule deviates from the internationally agreed definition of the leverage ratio that is part of the Basel III accord, initially published in 2010 by the Basel Committee of Banking Supervision on a mandate given by the Group of Twenty (G20) in 2008–09.
The Fed’s decision echoes separate congressional action in the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which was signed into law on March 27, 2020. Section 4014 of that legislation gives banks an option to ignore an accounting obligation known as current expected credit loss (CECL) provisioning, which most banks started doing in January 2020. As explained in an earlier post, CECL was introduced in response to a 2009 mandate from the G20, which was implemented in 2016 by the US Financial Accounting Standards Board (FASB) and separately earlier in 2014 by the International Accounting Standards Board (IASB), whose standards are applied in most jurisdictions other than the United States. By opting out of CECL, banks can avoid booking losses that are expected from the dramatic deterioration in the economic outlook from the pandemic and make their capital positions look correspondingly more flattering.
The Fed’s rule change and the Congress’s action in the CARES Act suggest an incipient trend of US departures from the comprehensive package of global financial standards enacted by various bodies under the G20’s authority since 2008. One earlier straw in the wind had come in November 2019, when the Fed and other federal bank regulators made a change to an arcane rule on measuring counterparty credit risk in certain transactions, which was also in breach of Basel III.
To be sure, the United States is far from the only offender, let alone the worst. Most notoriously, in 2014 the Basel Committee found the European Union “materially non-compliant” with Basel III, the only jurisdiction in that category—partly for similar counterparty-credit-risk shenanigans as in the US rule of November 2019. Neither are the recent American breaches wholly unprecedented, if one goes far enough back. US authorities had been reluctant to adopt the previous Basel II accord in the years before the financial crisis of 2008–10, for prudential reasons that the subsequent crisis experience largely vindicated. But from the first G20 summit in late 2008 to recent months, the United States had been the leading champion of G20 financial reforms, and that compliant stance was maintained under the first few years of the Trump administration. Even as some financial rules were relaxed, they were kept above the minimum levels set in international accords. Indeed, the final bits of Basel III were agreed in December 2017 after Randal Quarles, a Trump appointee, replaced his Obama-era predecessor Daniel Tarullo as the Fed’s point person in Basel Committee discussions.
The motivations for these changes are unconvincing
The US departures from global standards respond to specific demands from the US banking industry and some federal agencies, but whether they are in the US national interest is questionable. The experience of the COVID-19 crisis so far is precisely that strong capital standards such as Basel III are helpful protections against unforeseen events. Globally applied minimum prudential standards ensure a degree of international financial stability from which the United States in turn benefits. They also prevent the most blatant competitive distortions in international banking markets—a key driver of the first Basel accord in the 1980s. It is not clear that the leverage ratio breach has benefits that offset such advantages.
The motivations for the Fed’s new rule appear to include the fact that the pandemic-induced volatility has disrupted the Treasuries market and has also resulted in a sudden influx of deposits into US banks. But it is doubtful that leverage-ratio-related constraints played any role in the Treasuries market turmoil. As for the incoming deposits, banks can place them into deposits at the Federal Reserve, rather than Treasuries. A temporary exemption for such central bank deposits from the leverage ratio would not have breached Basel III in its current form. Moreover, the exemption of US sovereign exposures creates a highly problematic precedent that other jurisdictions with less creditworthy sovereign issuers may now be tempted to emulate, against the Basel Committee’s efforts to move its members’ consensus toward a more rigorous recognition of the risks that such exposures may carry. Similarly, concerns about procyclical impacts of CECL could and should have been addressed by using the standard’s embedded flexibilities, similar to what was recommended outside the United States by the IASB and implemented by the euro area and the United Kingdom, among others.
By breaching G20 standards, these decisions contribute to institutional erosion not only at the global level but also domestically. The breaches of Basel III are especially galling since Quarles now chairs the Financial Stability Board, an umbrella body whose permanent secretariat is located in the same building in Basel as the Basel Committee. On the domestic front the Fed also acted alone, as the other federal banking regulators such as the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation did not endorse its new rule as is customary. The congressional override of FASB (and in the same move of the US Securities and Exchange Commission, by delegation of which FASB has standard-setting authority), also is without precedent in nearly half a century.
The United States would lose from abandoning global financial standards
Possibly the recent breaches are one-offs, not the start of a broader trend of divergence. In a formal sense, both the Fed’s action on leverage ratio and Congress’s on accounting are temporary measures, even though they could be extended. They may, however, mirror a broader current pattern of the United States undermining the global rules-based order, from which the financial services area had been somehow ring-fenced until now. Be that as it may, these breaches are bad news for the authority of the G20, Financial Stability Board, and Basel Committee but probably not crippling. Just as US agencies did not implement Basel II, and FASB has declined to converge its standards with the IASB’s global ones, global financial standard-setting bodies can probably live with US lapses of compliance, at least for some time. It remains to be seen, however, how the implementation of the final piece of Basel III, which the Basel Committee has recently decided to delay by a year because of the COVID-19 pandemic, is ultimately affected by an eclipse of US leadership in that area.
If the noncompliance trend is confirmed, the most damaging consequences may be to the United States itself. The chair of the foundation that hosts and oversees FASB, in her letter (unsuccessfully) attempting to persuade Congress not to pass Section 4014 in the CARES Act, argued that the action “fundamentally undermines the longstanding and time-tested approach in the U.S. to transparent, rigorous and independent accounting standard-setting, which market participants rely upon and that plays a critical role in supporting our capital markets and broader economy.”
The United States has benefited immensely from upholding best-in-class financial standards and regulations. If these standards are lowered, US economic achievements, all things equal, may trend lower as well.