Michelle W Bowman: The consequences of bank capital reform
Speech by Ms Michelle W Bowman, Member of the Board of Governors of the Federal
Reserve System, at the International Swaps and Derivatives Association (ISDA) Board
of Directors, London, England, 26 June 2024.
* * *
I would like to thank the International Swaps and Derivatives Association (ISDA) for the
1
invitation to speak to you today. I appreciate the opportunity to engage with you on
matters that affect the swaps and derivatives industry, specifically how we can best
consider and address the potential consequences of bank capital reform measures,
both in the United States and around the world. Before doing so, I will share my views
on the economy and monetary policy in the United States.
Update on the Economy and Monetary Policy Outlook
Over the past two years, the Federal Open Market Committee (FOMC) has significantly
tightened the stance of monetary policy to address high inflation. At our meeting earlier
this month, the FOMC voted to continue to hold the federal funds rate target range at
51/4 to 5-1/2 percent and to continue to reduce the Federal Reserve's securities holdings.
After seeing considerable progress on slowing inflation last year, we have seen only
modest further progress this year. The 12-month measures of total and core personal
consumption expenditures (PCE) inflation have moved roughly sideways or slightly
down since December and remained elevated at 2.7 percent and 2.8 percent,
respectively, in April. The consumer price index (CPI) report for May showed 12-month
core CPI inflation slowing to 3.4 percent from 3.6 percent in April. However, with
average core CPI inflation this year through May running at an annualized rate of 3.8
percent, notably above average inflation in the second half of last year, I expect inflation
to remain elevated for some time.
The recent pickup in inflation in the first several months of 2024 was evident across
many goods and services categories, suggesting that inflation was temporarily lower in
the latter half of last year. Prices continue to be much higher than before the pandemic,
which is weighing on consumer sentiment. Inflation has hit lower-income households
hardest since food, energy, and housing services price increases far outpaced overall
inflation throughout this episode.
Economic activity increased at a strong pace last year but appears to have moderated
early this year. First-quarter gross domestic product growth was slower than in the
second half of last year, though private domestic final purchases continued to rise at a
solid pace. Continued softness in consumer spending and weaker housing activity early
in the second quarter also suggest less momentum in economic activity so far this year.
Payroll employment continued to rise at a solid pace in April and May, though slightly
slower than in the first quarter, partly reflecting increased immigrant labor supply.
Despite some further rebalancing between supply and demand, the labor market
remains tight. The unemployment rate edged up to 4.0 percent in May, while the
number of job openings relative to unemployed workers declined further to near its
prepandemic level. Labor force participation dropped back to 62.5 percent in May, which
suggests no further improvement in labor supply along this margin, as labor force
participation among those aged 55 and older has been persistently low.
At its current setting, our monetary policy stance appears to be restrictive, and I will
continue to monitor the incoming data to assess whether monetary policy is sufficiently
restrictive to bring inflation down to our target. As I've noted recently, my baseline
outlook continues to be that inflation will decline further with the policy rate held steady.
And should the incoming data indicate that inflation is moving sustainably toward our 2
percent goal, it will eventually become appropriate to gradually lower the target range
for the federal funds rate to prevent monetary policy from becoming overly restrictive.
However, we are still not yet at the point where it is appropriate to lower the policy rate,
and I continue to see a number of upside risks to inflation.
First, much of the progress on inflation last year was due to supply-side improvements,
including easing of supply chain constraints; increases in the number of available
workers, due in part to immigration; and lower energy prices. It is unlikely that further
improvements along this margin will continue to lower inflation going forward as supply
chains have largely normalized; the labor force participation rate has leveled off in
recent months below pre-pandemic levels; and an open U.S. immigration policy over
the past few years, which added millions of new immigrants in the U.S., may become
more restrictive.
Geopolitical developments could also pose upside risks to inflation, including the risk
that spillovers from regional conflicts could disrupt global supply chains, putting
additional upward pressure on food, energy, and commodity prices. There is also the
risk that the loosening in financial conditions since late last year, reflecting considerable
gains in equity valuations, and additional fiscal stimulus could add momentum to
demand, stalling any further progress or even causing inflation to reaccelerate.
Finally, there is a risk that increased immigration and continued labor market tightness
could lead to persistently high core services inflation. Given the current low inventory of
affordable housing, the inflow of new immigrants to some geographic areas could result
in upward pressure on rents, as additional housing supply may take time to materialize.
With labor markets remaining tight, wage growth has been elevated at around or above
4 percent, still higher than the pace consistent with our 2 percent inflation goal, given
trend productivity growth.
In light of these risks, and the general uncertainty regarding the economic outlook, I will
continue to watch the data closely as I assess the appropriate path of monetary policy.
The frequency and extent of data revisions over the past few years make the task of
assessing the current state of the economy and predicting how the economy will evolve
even more challenging. I will remain cautious in my approach to considering future
changes in the stance of policy.
It is important to note that monetary policy is not on a preset course. In my view, we
should consider a range of possible scenarios that could unfold when considering how
the FOMC's monetary policy decisions may evolve. My colleagues and I will make our
decisions at each FOMC meeting based on the incoming data and the implications for
and risks to the outlook. While the current stance of monetary policy appears to be at a
restrictive level, I remain willing to raise the target range for the federal funds rate at a
future meeting should the incoming data indicate that progress on inflation has stalled
or reversed. Restoring price stability is essential for achieving maximum employment
over the longer run.
Grappling with the Unintended Consequences of Bank Capital Reform
I will turn now to the issue of bank capital reform, and the implications of adopting and
implementing the Basel III "endgame" standards both in the United States and around
the world.
Considering capital and debt requirements in the aggregate
Capital requirements are an important component of the prudential regulatory
frameworks and interconnected banking and financial systems around the world. As
you know, the U.S. has lagged our E.U. and U.K. counterparts in fully implementing the
Basel III capital standards. In July 2023, the U.S. federal banking agencies issued a
public consultation on implementing what the U.S. calls the Basel III "endgame" capital
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reforms. The response to the U.S. capital proposal has been overwhelmingly negative,
including from a broad range of stakeholders. I have previously spoken at length about
my concerns with the proposal, and as public commenters have reviewed it, they have
identified additional areas of concern.3
In my view, the concerns are well-founded. The proposal acknowledged that the
revisions, if implemented, would result in an estimated 20 percent aggregate increase in
total risk-weighted assets across bank holding companies subject to the rule. Individual
impacts would vary not only by firm, but also by business line. For any particular
business line or product, the aggregate impact of the proposed capital changes could
result in a more significant increase, depending upon the firm's characteristics.
Consider the impact on business lines subject to the market risk capital rule. As noted
in the proposal, the revisions to the market risk rule alone would increase risk-weighted
assets from $430 billion to $760 billion for Category I and II firms, and from $130 billion
to $220 billion for Category III and IV firms.4
Even this example ignores the additive capital increases from other aspects of the rule,
such as the operational risk charge "overlay" that may separately result in a higher
capital charge for the same business line, if that line is also generating fee income. The
changes that may affect any particular financial product or service vary but could
include impacts across all aspects of the proposal. For many of the derivatives and
swaps activities in which banking entities engage, the aggregate impacts on different
business lines could result from changes to the market risk rule, the calculation of credit
valuation adjustments, and the treatment of securities financing transactions, among
others.
So far, what I have described are just the aggregate effects of capital increases that
would appear within the four corners of the U.S. Basel III endgame proposal. We know
that these changes do not exist in a vacuum. A particular firm can also be impacted by
changes to the global systemically important bank (G-SIB) surcharge and long-term
debt requirements. The firm's business planning would also need to consider existing
requirements, such as leverage and "total loss-absorbing capacity" requirements. By
design, these elements are intended to be complementary, often seeking to capture
different risks, operate as "backstop" capital standards, promote resiliency, and be
available for recapitalization in resolution.
Despite the goal that the capital framework operates in a holistic fashion, the
rulemaking process in the United States has taken a fragmented approach. This
process has seemed to ignore the interrelationships of the requirements. We cannot
fully understand the intended and unintended consequences of any regulatory reform,
including capital reform, without using a broader lens to consider the interconnections
and interrelationships among different capital and debt requirements that apply in the
banking system.
This narrow approach to rulemaking-focusing on a specific reform, without considering
the broader framework-has created a corresponding narrowness when we think about
the consequences of regulatory reform. This challenge has been particularly acute in
the capital and debt space simply because there are so many requirements that are
intended to operate in a complementary way, and that in the aggregate may overlap or
conflict, generating unintended consequences. The Federal Reserve has expressly
acknowledged the complementary nature of these requirements, for example in noting
that some leverage ratio requirements operate as a backstop to risk-based capital
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requirements. And yet, the discussions of costs and benefits of reform tend to
disregard the aggregate impact across rules, even when related reforms are proposed
at the same time and the aggregate impacts can be identified and assessed.6
Considering direct and indirect consequences
With respect to the Basel III "endgame" reforms, much of the discussion of
consequences has focused on the direct consequences to the availability and price of
credit, resulting from the proposed changes to risk-weighted assets. These issues
resonate with households and businesses. Everyone understands the direct impact on
their own household finances or their business's bottom line from higher costs of
lending. Often overlooked are the direct and indirect consequences of capital reforms
on financial products such as derivatives and swaps. These products can seem exotic
to the public, but we know they play a significant role in the financial system and the
broader economy, including commodities price hedging by end-users, such as
agricultural producers. And it is certainly foreseeable that proposed capital reforms
could impair market liquidity.
We also know that regulatory reforms-especially capital reforms with a direct link to
particular products, services, and markets-can cause broader changes in firm behavior.
Some banks may raise prices on particular products based on their internal allocation of
increased capital charges. And some banks may discontinue certain products or
services that cannot be offered in a cost-effective way. These choices will impact the
competitive landscape into the future, and in some cases-such as where significant
economies of scale are required to offer a product or service-the end result may be that
some banks exit certain product markets, resulting in increased concentration and
higher prices for households and businesses.
While I am acutely aware of our need to consider these costs and price effects, I am
also aware that regulators sitting in Washington, D.C. are not well-equipped to query
and understand these real-world consequences of reform. In my view, the commenter
feedback we have received on these issues has helped to illuminate these
consequences. My hope is that we take them into account when moving forward to
implement the Basel III endgame standards.
The path forward
I do see a path forward to implement Basel III, one that not only addresses the overall
calibration and international consistency and comparability, but also makes more
granular changes that will improve the effectiveness and efficiency of the rule. In terms
of this path, I will briefly outline what I see as necessary procedural steps, while also
providing a non-exclusive list of substantive changes that I believe are necessary to
improve the proposal.
In October 2023, the Federal Reserve initiated a data collection to gather information
from the banks affected by the U.S. proposal. I am hopeful that these data will allow
regulators to better understand the proposal's impact and identify areas for revision.
Any next step in this rulemaking process will require broad and material changes. It
should also be accompanied by a data-driven analysis of the proposal and be informed
by the significant public input received during the rulemaking process. This should
assist policymakers in creating a path to improve the rulemaking. My hope is that
policymakers pay closer attention to the balance of costs and benefits while considering
the direct and indirect consequences of the capital reform.
I have previously identified a number of specific areas and procedural steps that would
be necessary to address in any future efforts to revise this proposal. Some of these
issues include
addressing redundancy in the capital framework (for example, between the new
market risk and operational risk requirements, and the stress capital buffer);
recalibrating the market risk rule specifically, where some of the biggest outlier
increases in risk-weighted assets would appear;
adopting a more reasonable treatment for non-interest and fee-based income
through the operational risk requirements, which could deter banks from
diversifying revenue streams, even though such diversification can enhance an
institution's stability and resilience;
reviewing the impact of capital requirements, including leverage ratio
requirements, on U.S. Treasury market intermediation and liquidity;
incorporating tailoring in the applicability of Basel III capital reforms, specifically
looking at whether each element of the Basel III capital proposal is appropriate for
non-G-SIB firms that are not internationally active; and
re-proposing the Basel III standards to address the broad and material reforms
that I believe should be included in any final rule, including granular changes to
address the specific issues raised by commenters, as appropriate.7
While these steps would be a reasonable starting place, they are not a replacement for
a data-driven analysis and a careful review of the comments submitted. This would
result in a better proposal that includes not only changes to address these concerns,
but also the many other concerns raised by the public.
Closing Thoughts
It has been a pleasure speaking with you today. Your industry plays an important role
not only in the U.S. economy, but also in the broader world economy. It is imperative
that regulators not lose sight of the practical implications of regulatory reform, even as
the U.S. considers the next steps in moving forward to adopt the final Basel III capital
reforms.
1
The views expressed here are my own and not necessarily those of my colleagues on
the Federal Open Market Committee or the Board of Governors of the Federal Reserve
System.
2
Board of Governors of the Federal Reserve System, Federal Deposit Insurance
Corporation (FDIC), and Office of the Comptroller of the Currency (OCC), "Agencies
Request Comment on Proposed Rules to Strengthen Capital Requirements for Large
Banks," news release, July 27, 2023; OCC, Board of Governors of the Federal Reserve
System, and FDIC, "Regulatory Capital Rule: Large Banking Organizations and
Banking Organizations with Significant Trading Activity (PDF)," 88 Fed. Reg. 64,028-
64,343 (September 18, 2023).
3
See dissenting statement, " Statement by Governor Michelle W. Bowman " on the
proposed rule to implement the Basel III endgame agreement for large banks, news
release, July 27, 2023 ; Michelle W. Bowman, " Remarks on the Economy and
Prioritization of Bank Supervision and Regulation (PDF)" (speech at the New York
Bankers Association's Financial Services Forum, Palm Beach, Florida, November 9,
2023); Michelle W. Bowman, " The Path Forward for Bank Capital Reform (PDF) "
(speech at Protect Main Street, sponsored by the Center for Capital Markets at the U.S.
Chamber of Commerce, Washington, D.C., January 17, 2024).
4
OCC, Board of Governors of the Federal Reserve System, and FDIC, Notice of
Proposed Rulemaking, "Regulatory Capital Rule: Large Banking Organizations and
Banking Organizations with Signfiicant Trading Activity," 88 Fed. Reg. 64,028, 64,168,
table 11 (September 18, 2023).
5
See, e.g., Board of Governors of the Federal Reserve System, Interim Final Rule and
Request for Comment, "Temporary Exclusion of U.S. Treasury Securities and Deposits
at Federal Reserve Banks from the Supplementary Leverage Ratio (PDF)," 85 Fed.
Reg. 20,578, 20,579 (April 14, 2020) ("This interim final rule does not affect the tier 1
leverage ratio, which will continue to serve as a backstop for all banking organizations
subject to the capital rule.").
6
See, e.g., OCC, Board of Governors of the Federal Reserve System, and FDIC,
Notice of Proposed Rulemaking, "Long-Term Debt Requirements for Large Bank
Holding Companies, Certain Intermediate Holding Companies of Foreign Banking
Organizations, and Large Insured Depository Institutions (PDF)," 88 Fed. Reg. 64,524,
64,551, n. 97 ("The agencies recognize that their Basel III reforms proposal would, if
adopted, increase risk-weighted assets across covered entities. The increased
riskweighted assets would lead mechanically to increased requirements for LTD under the
LTD proposal. The increased capital that would be required under the Basel III proposal
could also reduce the cost of various forms of debt for impacted firms due to the
increased resilience that accompanies additional capital (which is sometimes referred to
as the Modigliani-Miller offset).The size of the estimated LTD needs and costs
presented in this section do not account for either of these potential effects of the Basel
III proposal.") (emphasis added). Even when the agencies estimate the effect of a
proposal on other rules, the impact analysis tends to be narrow, such as focusing on
the estimated shortfall that would be created by the interrelated rules and may overlook
other pending rules. See, e.g., OCC, Board of Governors of the Federal Reserve
System, and FDIC, "Regulatory Capital Rule: Large Banking Organizations and
Banking Organizations with Significant Trading Activity (PDF)," 88 Fed. Reg. at 64,171
(noting that the proposed revisions to the calculation of risk-weighted assets under the
Basel III endgame proposal would affect the risk-based TLAC and LTD requirements
applicable to Category I bank holding companies but disregarding the pending proposal
that would expand long-term debt requirements to a broader set of firms).
7
See dissenting statement, " Statement by Governor Michelle W. Bowman " on the
proposed rule to implement the Basel III endgame agreement for large banks, news
release, July 27, 2023; Michelle W. Bowman, "Remarks on the Economy and
Prioritization of Bank Supervision and Regulation (PDF)"; Michelle W. Bowman, " The
Path Forward for Bank Capital Reform (PDF)."