Statement of the Financial Economists Roundtable: Bank Capital as a Substitute for Prudential Regulation

The Financial CHOICE Act recently passed by the House proposes to create an “off†ramp†that would allow banks to escape burdensome prudential regulation if the ratio of their equity capital to their total assets is 10% or more. The Financial Economists Roundtable supports this idea as a means of reducing regulatory costs, but believes some additional safeguards are needed. A capital ratio of 10% may not be high enough to discourage banks from excessive risk taking. A solution is to have two capital requirements for banks choosing the off†ramp: one absolute (as proposed in the act) and one risk†based. The FER believes that many banks will prefer this regime to the current burdensome prudential regulation, especially if regulators simplify the setting of risk weights and make them more rule†based. Regulators setting minimum capital requirements should consider not only a bank’s stand†alone risk, but also the systemic risk posed by banks, as well as the tendency of accounting measures of income and assets to overstate the economic value of banks’ equity capital. The Financial Choice Act would also eliminate useful elements of ongoing supervision and regulation, not all of which can be addressed by higher capital alone. Furthermore, to facilitate regulatory learning about risks, off†ramped banks should continue to report the data that regulators use for stress tests, even if they are no longer subjected to the discipline of stress tests. Finally, the act is viewed as too permissive in its treatment of off†ramped banks that get into trouble. To prevent gaming of regulation, FERC recommends that off†ramped banks that subsequently fall below the minimum requirements should be required to raise new capital immediately.