the full issue

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the full issue

4th Quarter 2014 | Volume 2, Issue 4
The Quarterly Journal of The Clearing House
Financial
Resiliency
Promoting Stability and Growth
Macroprudential Policy and
Financial Resiliency
andall S. Kroszner, Booth School of
R
Business, University of Chicago
Macroeconomic Modeling and
Financial Stability
ndrew W. Lo, Sloan School of
A
Management, MIT
The Implications of Higher
Capital Requirements
Alexey Levkov and Clark Peterson,
The Clearing House
Balancing the Risks and
Benefits of Uncleared Swaps
Donna Parisi and Barnabas Reynolds,
Shearman & Sterling LLP
My Perspective
Robert Ceske of KPMG on Liquidity
Also Featuring
State of Banking
With Brian Moynihan, Chairman and CEO of
Bank of America
Prospects for Financial
Services Legislation in the
114th Congress
Samuel Woodall III, Sullivan & Cromwell LLP
TCH Analytics
A Quantitative Snapshot of Trends in Banking
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Coming Up for
Banking Perspective
In its next issue, Banking Perspective will feature
commentary and analysis on recent trends in
the global economy and the unique challenges
to foreign banking organizations posed by the
international regulatory framework. The first
quarter issue of Banking Perspective will also
feature reflection by CFPB Director
Richard Cordray on efforts to enhance
consumer protection.
How to Submit
How to Subscribe
Banking Perspective welcomes your submissions. Articles should be between
2,500-4,000 words and should support an identifiable position in the context
of bank policy or bank payments issues. While technical in nature, articles
should be clear, concise, readable, and accessible to individuals with varying
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publish and distribute material at its discretion.
Banking Perspective, the quarterly journal of The Clearing
House, is a forum for thought leadership from banking
industry executives, regulators, academics, policy experts,
industry observers, and others. Articles focus on themes
in the bank regulatory landscape and innovation trends
in bank payments, providing timely analysis of the most
important issues shaping today’s banking industry.
To submit an article for consideration, e-mail submissions@theclearinghouse.org.
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4th Quarter 2014 | Volume 2, Issue 4
The Quarterly Journal of The Clearing House
Featured Articles
16
Fire Extinguishers and Smoke
Detectors: Macroprudential
Policy and Financial Resiliency
Since the financial crisis, a debate has emerged about the
appropriate role of central banks as an ex ante “smoke
detector” and as an ex post “fire extinguisher.” While a
greater focus on financial stability concerns is valuable,
policymakers should not underestimate the difficulty of
undertaking effective macroprudential policy and should be
mindful of significant challenges to implementing such policy,
challenges that could ultimately undermine market discipline.
by R
andall S. Kroszner, Booth School of Business,
University of Chicago
22
Financial Stability: Lessons
from the Crisis
The dynamic stochastic general equilibrium model (DSGE)
marked a major milestone by capturing the dynamic change
of economic variables over time. However, many DSGE models
were exposed as having omitted critical structural linkages
relevant to the financial crisis. To address these deficiencies,
existing DSGE models should be enhanced to better incorporate
the role of the financial sector and financial markets. In
addition, these models should reexamine key micro-foundations
of the model and consider behavioral components.
by Andrew W. Lo, Sloan School of Management, MIT
32
State of Banking:
A Conversation With
Brian Moynihan
Paul Saltzman interviews Bank of America Chairman and
CEO Brian Moynihan, who discusses the opportunities
facing the banking industry, his new role as Chairman of The
Clearing House, and the implications of technology growth
on cybersecurity, payments, and bank business models.
36
Too Much of a Good Thing:
The Implications of Higher
Capital requirements are important to ensure that externalities
associated with a bank’s failure are borne by the bank alone.
However, there are both private and social costs associated
with requiring banks to hold more capital. Empirical and
theoretical evidence indicate that there are significant trade-offs
in requiring higher levels of bank equity capital. Policymakers
should seek to identify the costs and benefits of requiring more
capital at banks and calibrate rulemakings accordingly.
by Alexey Levkov and Clark Peterson, The Clearing
House
50
The Art of the Possible:
Prospects for Financial Services
Legislation in the 114th
Congress
With a Republican-controlled Congress and a Democratic
president, the conventional wisdom is that the next two
years will portend an extended and partisan political
stalemate that will stymie any prospect for enactment of
meaningful financial services legislation. However, real
opportunities for the advancement of financial services
legislation are in play. In fact, if recent history is any
indicator, Congressional Republicans will have the chance
to do something that has been off limits for the last several
years: amend Dodd-Frank.
by Samuel Woodall III, Sullivan & Cromwell LLP
62
Margin for Error: Balancing the
Risks and Benefits of Uncleared
Swaps
Margin requirements for uncleared derivatives are intended to
reduce counterparty credit risk, limit contagion, and incentivize
the central clearing of derivatives trades. However, they risk fueling
potentially negative outcomes such as straining market liquidity
and subsequently driving activity to the shadows. In addition, the
ambiguous scope of their extraterritorial application threatens to
introduce new forms of uncertainty and legal risk into cross-border
transactions.
by Donna Parisi and Barnabas Reynolds,
Shearman & Sterling LLP
D e pa r t m e n t s
8
For the Record
10
My Perspective
TCH Association President Paul Saltzman calls for a
reconceptualization of banking resilience and discusses key
considerations for macroprudential policy with this in mind.
As banks and other market participants were under-prepared for
the liquidity challenges of the crisis, heightened focus on liquidity
is justified. However, regulators should be wary of how new
liquidity regulations interact with capital rules, impact greater risk
management practices, and drive liquidity risk to the shadows.
by Robert Ceske, KPMG
48
72
74
84
86
TCH Analytics
A snapshot of selected trends in the banking sector.
Editor Clark Peterson
Associate Editor David Helene
Banking Perspective is the quarterly journal of
The Clearing House. Its aim is to inform financial
industry leaders and the policymaking community on
developments in bank policy and payments. The journal
is a forum for thought-leadership from banking industry
executives, regulators, academics, policy experts,
industry observers, and others.
Established in 1853, The Clearing House is the
oldest banking association and payments company in
the United States. It is owned by the world’s largest
commercial banks, which collectively hold more than half
of all U.S. deposits and which employ over one million
people in the United States and more than two million
people worldwide. The Clearing House Association L.L.C.
is a nonpartisan advocacy organization that represents
the interests of its owner banks by developing and
promoting policies to support a safe, sound and
competitive banking system that serves customers and
communities. Its affiliate, The Clearing House Payments
Company L.L.C., which is regulated as a systemically
important financial market utility, owns and operates
payments technology infrastructure that provides safe
and efficient payment, clearing and settlement services
to financial institutions, and leads innovation and
thought leadership activities for the next generation
of payments. It clears almost $2 trillion each day,
representing nearly half of all automated clearing house,
funds transfer and check-image payments made in the
U.S.
By the Numbers
A quantitative look at the contributions of banks to the U.S.
economy.
Research Rundown
Highlights from academic and policy research on issues in the
banking and payments industry.
Featured Moments
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Contributors
Randall Kroszner
Randall S. Kroszner
served as a Governor of
the Federal Reserve
System from March
2006 until January 2009.
During his time as a
member of the Federal
Reserve Board, he chaired the committee on
Supervision and Regulation of Banking
Institutions and the committee on Consumer
and Community Affairs. He also represented
the Federal Reserve Board on the Financial
Stability Forum (now called the Financial
Stability Board), the Basel Committee on
Banking Supervision, and the Central Bank
Governors of the American Continent.
He is currently a Research Associate of the
National Bureau of Economic Research and
serves on the Committees on Economic Statistics and on Economic Education of the American Economics Association. Dr. Kroszner was a
member of the President’s Council of Economic
Advisers (CEA) from 2001 to 2003.
Alexey Levkov
Dr. Levkov is responsible for quantitative
analysis supporting the
advocacy initiatives at
The Clearing House,
primarily focusing on
capital and liquidity.
Prior to joining The Clearing House, Dr.
Levkov was a senior financial economist in
the Supervision and Regulation Department
at the Federal Reserve Bank of Boston.
6
Banking Perspective Quarter 4 2014
Between 2011 and 2014 he served as a lead
model developer for the supervisory
wholesale model for CCAR, working with
teams at the Federal Reserve Bank of
Chicago and the Board of Governors. His
other responsibilities included reviewing
advanced-approach risk models and working
with the Basel Coordination Committee
(BCC) as well as conducting research related
to financial stability and labor markets.
Dr. Levkov’s work has been published
in several academic journals and he is a
recipient of the Brattle Group Award for a
distinguished paper published in The Journal
of Finance in 2010. He received his Ph.D. and
M.A. in Economics from Brown University
and his B.A. in Economics and Statistics
from The Hebrew University of Jerusalem,
Israel.
Andrew W. Lo
Andrew W. Lo is
the Charles E. and
Susan T. Harris Professor, a Professor of
Finance, and the
Director of the
Laboratory for
Financial Engineering at the MIT Sloan
School of Management.
Prior to MIT Sloan, he taught at the
University of Pennsylvania Wharton School
as the W.P. Carey Assistant Professor of
Finance from 1984 to 1987, and as the W.P.
Carey Associate Professor of Finance from
1987 to 1988. His research interests include
the empirical validation and implementation
of financial asset pricing models; the pricing
of options and other derivative securities;
financial engineering and risk management; and, most recently, evolutionary and
neurobiological models of individual risk
preferences and financial markets, among
many others.
Dr. Lo is founder and chief scientific officer of AlphaSimplex Group, LLC, a quantitative investment management company based
in Cambridge, Massachusetts.
Donna M. Parisi
Donna M. Parisi is a
partner, Co-Practice
Group Leader of Shearman & Sterling’s Asset
Management Group
(which includes the
firm’s Derivatives &
Structured Products team) and former
member of the firm’s Executive Group. Ms.
Parisi’s practice focuses on derivative,
structured product, securitization, capital
market and commodities matters. Legal
directories such as Chambers Global, Chambers USA, Legal 500 US and IFLR 1000have
for several years consistently ranked Ms.
Parisi as a leader in her field, and in 2014
Ms. Parisi was selected for a Lawyer
Monthly Women in Law award in recognition of outstanding legal work.
Specifically, Ms. Parisi has assisted clients
in the development and structuring of new
financial products and is experienced in the
negotiation and documentation of OTC derivative transactions, including equity, credit,
hedge fund, fixed income, commodity and
currency swaps and options, among others.
Clark W. Peterson
Clark Peterson is
Senior Vice President
of Strategy and Public
Policy at The Clearing
House. He focuses on
policy research and
analysis and helps lead
the strategic and operational agenda of The
Clearing House Association. He is also the
editor of The Clearing House’s quarterly
publication, Banking Perspective, which he
helped found. Mr. Peterson began his career on Capitol
Hill. He was a policy adviser in the U.S.
Senate, focusing on economic, fiscal,
and financial policy issues. He served as
Legislative Director for a senior member of
the Senate and was a Legislative Assistant
before that. During this time, he advised
on the enactment of the Dodd-Frank Wall
Street Reform and Consumer Protection
Act (2010). He also advised a member of
the House Agriculture Committee during
consideration of the Food, Conservation and
Energy Act of 2008. Mr. Peterson received Bachelors of Arts
degrees in both economics and political science from Hillsdale College. He holds a MBA
from the Harvard Business School.
Barnabas Reynolds
Barnabas Reynolds is
head of the global
Financial Institutions
Advisory & Financial
Regulatory Group at
Sherman & Sterling.
He advises the full
range of market participants on their
businesses in the London and European
markets. His practice focuses on global legal
risk management, including in the context of
cross-border legal, regulatory and insolvency
regimes. In addition, from Q1 2010 to Q1
2014, he served as an elected member of the
firm’s Policy Committee. Barnabas is
recognized as a leading UK and EU financial
regulatory lawyer. He was named the Times
Lawyer of the Week in December 2013, is on
the 2013 London Super Lawyers list and was
selected as one of the Best Lawyers in the
UK in insurance law.
Cromwell from Capitol Hill, where he served
on the staff of the Committee on Banking,
Finance and Urban Affairs of the U.S. House
of Representatives.
Mr. Reynolds has been actively involved
in helping to shape, analyze and comment
upon the global regulatory reforms that
arose out of the recent financial crisis.
Samuel Woodall III
Sam Woodall is a
partner in Sullivan &
Cromwell’s General
Practice Group. He
represents a variety of
clients before the U.S.
Congress, as well as
executive branch and federal financial
regulatory agencies. Mr. Woodall has
participated, on behalf of the Firm’s clients,
in the Congressional deliberations leading to
enactment of the Gramm-Leach-Bliley Act
(1999), the USA PATRIOT Act (2001), the
Sarbanes-Oxley Act (2002), the Financial
Services Regulatory Relief Act (2006) and,
most recently, the Dodd-Frank Wall Street
Reform and Consumer Protection Act
(2010), as well as the regulatory implementation of these statutes. He has also advised
the Firm’s clients in connection with federal
legislation and regulation governing student
lending, industrial banks, private equity
firms, and Government Sponsored Enterprises. Mr. Woodall came to Sullivan &
7
For the Record
Paul S altzman
President of The Clearing House Association, EVP and
General Counsel of The Clearing House Payments
Company
The banking system plays a unique and vital
role in the economy’s health. The services and
functions that banks perform comprise our
economy’s circulatory system, creating and
delivering the financial equivalent of oxygen
throughout the economy to allow it to grow. As
such, banks enable consumers, businesses,
and industries to achieve a level of consumption and output that would otherwise be
impossible—contributing to job creation, higher
living standards, and long-term growth and
prosperity.
stable funding ratio and a total loss absorbing
capacity requirement—reached finalization at
the international level. Meant to ensure sufficient long-term liquidity at banks and improve
their resolvability, respectively, these two reforms have been viewed as key missing pieces
in safeguarding the stability of the system.
The financial crisis demonstrated, however,
that the consequences of a disruption to the
system can put our economy on the brink of
cardiac arrest. Just as it’s critical for all of us
to ensure our own health—to exercise, eat well,
and go to the doctor—banks and policymakers
must ensure the resilience of the banking
system.
I believe that the concept of banking
system resilience must incorporate a key
trade-off that’s been largely overlooked: the
trade-off between stability and growth. Banking system resilience, properly understood,
should not refer merely to the ex post state of
the industry in the wake of a shock. Rather,
the appropriate concept of resilience must
also capture the ex ante ability of the system
to effectively perform the critical services and
functions that support economic growth. We
must begin to assess not only the components of financial stability but also those related to macroeconomic performance: credit
extension, cost of credit, and market liquidity,
for example.
In the traditional view, this means that we
must ensure that the system, on a standalone
basis, can withstand shocks and continue
to perform its functions in the face of such
shocks. This has been the ultimate goal of our
post-crisis regulatory reform efforts. Understandably, policymakers have primarily sought
to achieve stability through the development
and subsequent implementation of a whole
host of new regulatory reforms. In general,
these reforms aim to ensure appropriate levels
of capital and liquidity at banks, reduce overall
levels of interconnectedness, and ensure the
resolvability of any failing bank without the
need of taxpayer funds.
Substantial progress has been made. One
need look no further than the last few weeks,
during which two critical measures—the net
8
In the wake of all of these new regulatory
reforms, the banking system is certainly more
stable. But it is unclear to me that it is sufficiently resilient. What do I mean by this?
Our bank regulatory framework must be
crafted with this equilibrium in mind. We
should seek an optimal state where regulations provide for a banking system not only
stable enough to withstand systemic shocks
but also robust enough to maximize sustainable economic growth.
The macroprudential approach to financial
regulatory reform has been the approach
predominantly adopted by regulators since
the crisis. This approach, however, incorporates
substantial regulatory judgment, a time-varying component, and can easily veer into the
top-down economic fine-tuning long discarded
in American economic policymaking. There are
critical trade-offs to this approach that cannot
be ignored. As I have said before, unlike microprudential mistakes, macroprudential mistakes
are likely to have macroeconomic consequences. It is therefore of critical importance that we
understand the trade-offs involved and that
rules are calibrated accordingly.
Former Federal Reserve Governor Randy
Kroszner covers this ground well in his article
Fire Extinguishers and Smoke Detectors: Macroprudential Policy and Financial Resiliency.
He outlines the objectives policymakers should
strive for in constructing macroprudential rules,
and he argues that “it is crucial…to assess the
costs and benefits in terms of the potential
benefits of greater stability and resiliency
against potential costs in terms of lower
economic growth.” This is an enormously challenging proposition, and he therefore cautions
policymakers on the certain pitfalls they may
face, including difficulties related to developing
appropriate “warning flags,” the appearance of
arbitrary decision making, and political risk.
The debate over the appropriate level of
bank capital requirements illustrates the
growth-stability concept of financial resiliency.
In their article Too Much of a Good Thing: The
Implications of Heightened Capital Requirements, Alexey Levkov and Clark Peterson use
standard corporate finance frameworks to
describe the firm-level trade-offs associated
with a bank’s capital structure. They conclude
that bank capital structure decisions matter,
and that there are costs and benefits associated with higher equity levels. They connect
the firm-level trade-offs to the macroeconomic
trade-offs with respect to stability and growth,
and then recommend that policymakers weigh
these trade-offs carefully when contemplating
heightened capital requirements.
In addition to assessing the trade-offs
inherent in particular regulations, like capital, it’s crucial that we begin to assess how
different types of regulations are interacting
with each other in a comprehensive way. The
capital framework, for example, is comprised
of a risk-based approach, a leverage ratio, and
annual stress testing. Similarly, the liquidity
framework is comprised of a short-term liquidity
rule, a long-term liquidity rule, annual stress
testing, and likely a forthcoming rule governing short-term wholesale funding. Then there
are single counterparty credit limits, rules to
enhance resolvability, derivatives requirements,
and structural requirements, just to name a few.
We need to carefully examine how these pieces
interact.
Robert Ceske of KPMG highlights a prime
example of this need in this issue’s My
Perspective, in which he articulates how our
approach to capital and liquidity risk management is currently bifurcated and how the critical
connections between capital and liquidity are
disconcertingly underemphasized by the regulatory framework. Rob suggests that the industry
and regulators work together to better capture
the interconnectivity of capital and liquidity and
ensure that liquidity issues and challenges are
integrated and assessed in the capital planning
process. Like Rob, I believe it is critical to take a
hard look at the complete set of trade-offs and
net impact of these rulemakings, so that we
understand how they affect overall resilience.
In addition to the net trade-offs of these
rulemakings, it is also important to understand
the net impact of these reforms on overall risk.
Donna Parisi and Barney Reynolds describe
how margin requirements for uncleared swaps,
for example, could, on a net basis increase
overall risk in their article Margin for Error:
Balancing the Risks and Benefits of Uncleared
Swaps. By straining market liquidity, complicating cross-border transactions, and transferring
risks to shadow banks, this measure has clear
implications for resilience. If a core effect of
rules is to push risk to a part of the financial
system that is held to a lower standard of risk
management and stability, they could in fact
adversely affect overall resilience.
As we continue to complete and refine the
post-crisis regulatory framework, we must also
begin to look forward. People often wonder
how we missed the warning signs from the
last crisis and how we can ensure that we
don’t miss the warning signs of the next one.
One technical, but fascinating, component of
this is the world of macroeconomic modeling.
MIT’s Andrew Lo, in his article Macroeconomic
Modeling and Financial Stability: Lessons from
the Crisis, discusses the previous shortcomings of our macroeconomic models—namely,
that the pre-crisis vintage didn’t incorporate a
financial system into the models themselves.
Andy argues that dynamic stochastic general
equilibrium models, which are the state-of-theart pre- and post-crisis macroeconomic models, need to be better aligned to the financial
sector and better reflect its true impact on the
greater economy.
To steal a quote from Andy’s piece, “being
precisely wrong is not as helpful as being
approximately right.” We cannot afford for our
financial regulatory framework to be precisely
wrong. A better conceptualization of banking
resilience that recognizes important trade-offs
can help us get the balance approximately right.
Lastly, we are thrilled to feature a conversation with Brian Moynihan, Chairman and CEO
of Bank of America and the incoming Chairman
of The Clearing House, in this issue’s State of
Banking interview. He offers insights on critical
issues the banking industry faces—insights that
only an industry leader like Brian can provide.
He covers U.S. and global economic growth, the
need for a customer-driven strategy, and how
the industry can adapt to rapid technological
change. We at The Clearing House look forward
to tackling many of these issues under Brian’s
leadership in 2015. 
9
My Perspective
Liquidity risk received little attention
prior to the recent financial crisis. Since
then, however, banks have improved their
understanding of the challenges they face in
this area. The crisis also led to heightened
regulatory requirements for bank liquidity
risk management. On September 3, 2014,
U.S. regulators released the final rule for
the Liquidity Coverage Ratio (“LCR”). On
October 31, 2014, the Basel Committee on
Banking Supervision updated its standard
for the Net Stable Funding Ratio (“NSFR”).
Robe rt Ceske
Principal, KPMG
Rob Ceske is a Principal with KPMG LLP and leads the firm’s
national treasury and liquidity practices. As a risk practitioner
and strategic advisor, Rob has helped financial and nonfinancial companies to improve their funding and liquidity
risk management, governance and strategy, as well as their
asset/liability management, market, credit and operational
risk. Rob served as the Chief Risk Manager for GE/GE Capital’s
Corporate Treasury from 2002 to 2010, where he received
the 2009 Pinnacle Award and 2006 President’s Award from
the Association for Financial Professionals, the GE Treasurer’s
Award and two Alexander Hamilton Awards. Rob also worked in
derivative product groups at J.P. Morgan and Merrill Lynch.
Acknowledgemen t s
The author would like to thank Marshal Auron and Jeff Dykstra
for their valuable contributions to this article. The views and
opinions expressed herein are those of the author and do not
necessarily represent the views and opinions of KPMG LLP.
Together, these regulatory requirements,
once they are fully adopted in the U.S.,
will increase holdings of liquid assets at
regulated financial institutions. But will
they really achieve the broader objective
of helping create a more stable financial
system?
Clearly, some banks and other market
participants were under-prepared for the
liquidity challenges of the crisis and a
heightened focus on liquidity is justified.
However, liquidity risk is created by maturity
transformation, which is a fundamental
risk of banking. Holding additional liquidity
is always easy to justify. The question is:
where’s the limit?
While the LCR and NSFR are not at
risk of putting banks out of business,
are we squeezing on a balloon? Could
we be forcing banks to have “too much”
liquidity—not too much in the sense that
banks are not better protected from liquidity
crises than they were in the past, but in
the fact that maturity transformation and
other fundamental tenets of the banking
10
sector could move away from the regulated
financial sector?
Some of the post-crisis reforms could
be shifting us towards a regime where
liquidity risk is pushed to those without the
traditional liquidity backstop. We have seen
this in limited cases so far (e.g., selling
mortgage servicing rights to nonbanks,
adding call provisions on debt, and adding
notice periods on certain withdrawals), but
expect more as banks comply with LCR
requirements.
We should expect that banks, which
are now faced with an explicit cost of
providing liquidity to customers, will push
such liquidity risks to their customers and
counterparties, where possible. This is a
rational microeconomic decision. However,
in the end, will we have created a financial
system that is less able to withstand
liquidity shocks, as liquidity will increasingly
be provided by individuals and companies
that do not have access to Federal Reserve,
Federal Home Loan Bank system, and other
forms of government-supported backstop
liquidity?
Liquidity crises are driven by a loss of
confidence on the part of counterparties,
customers, and others who have
connections to a financial institution.
Government intervention during the crisis
supported the liquidity needs of individual
firms and the system, but it also served an
extremely valuable role of helping restore
public confidence in banks and other
financial intermediaries. Unfortunately,
public (and policymakers’) concerns about
Congratulations to
H. Rodgin Cohen,
Senior Chairman of
Sullivan & Cromwell,
on receiving our 2014
Chairman’s Lifetime
Achievement Award.
The award recognizes a leader
in the banking field whose
professional contributions
have positively shaped the
industry throughout his or her
professional career.
Past recipients include former
Mayor Michael Bloomberg and
former Federal Reserve Vice
Chairman Donald Kohn.
“too big to fail” have left a persistent desire
to avoid a repeat of the government’s
support measures. But without similar
government support in future crises—even
with banks that have more capital and
liquidity, might the outcome be worse? The
government must be in a position to provide
such market confidence in the future.
‘‘
be cautious of unintended consequences.
Liquidity regulation also needs greater
customization. The LCR does not have any
adjustment for banks’ internal strength in
risk management, crisis planning, or other
such factors in Pillar I liquidity requirements
(which currently include holding enough
“High Quality Liquid Assets” to cover
We should seek broader approaches to
liquidity management that take into account
other factors, such as capital, risk management,
and business mix—and also be cautious of
unintended consequences.
While there is no “right answer” to how
much liquidity to hold (or force banks to
hold), a recent Fed comparison of banks’
most severe internal 30-day liquidity stress
tests and their LCR calculations showed that
the LCR requirement exceeded banks’ most
severe internal stress test for two thirds of
these banks.1
We should seek broader approaches
to liquidity management that take into
account other factors, such as capital, risk
management, and business mix—and also
1
Miller, Bart, Market & Liquidity Supervision,
Federal Reserve Bank of Chicago, “Liquidity
Supervision of Large Banking Organizations,”
October 28, 2014
12
net outflows in a regulator-prescribed
stress environment). As part of Enhanced
Prudential Standards requirements,
regulators expect firms to create and
manage to idiosyncratic liquidity stress
measures, but the LCR is the constraint
for most. Internal stress tests are meant
to complement and supplement the LCR
buffer, but when LCR factors are immovable,
regardless of individual firm history/behavior,
and the LCR ratios are lower than internal
stress tests, the LCR becomes the de facto
constraint on liquidity.
A key concern is that banks’ internal risk
management departments will become more
focused on managing regulatory constraints
and requirements than on managing the
risks of the bank (regardless of regulation).
Such a response is unavoidable when
complying with new regulatory requirements
is overwhelming internal risk departments.
Bank boards of directors have also felt this
strain. During KPMG’s recent governance
survey2, numerous directors cited the strain
compliance efforts had on their boards and
how such requirements necessarily reduced
the strategic input that these directors felt
they could provide.
The challenge is that such a dramatic
short-term increase in compliance efforts
will by necessity reduce the focus of
second- and third-line-of-defense personnel
on looking for risks outside of regulatory
mandates. We will be well prepared to fight
the last crisis, but banks’ internal risk groups,
and the diversity of their detection and
mitigation techniques, will be weaker relative
to an unanticipated crisis. A wise goal would
be to balance regulation with the historical
“collaborative challenge” between firms and
supervisors.
There is still much to do in the
area of liquidity risk management.
While supervisors have moved toward
macroprudential supervision for capital
and liquidity risk, they are still early in
incorporating interconnectedness between
firms into supervision. And, to some extent,
supervisory and financial institution focus
is currently bifurcated between capital and
liquidity risk management. However, it is
important for both regulators and financial
institutions to consider the relationships
between these two crucial aspects of
financial resiliency. True, elements of
2
KPMG and Association for Financial Professionals,
“Raising the Bar for Treasury Risk Governance,”
2014
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liquidity risk are captured in CCAR and
capital planning, but Pillar I requirements
should have a stronger connection between
capital and liquidity, as banks with strong
capital positions have been much less
susceptible to liquidity crises (likely due to
their stronger inherent financial resiliency
as well as the higher perception of financial
strength).
There are also opportunities to derive
and define alternative liquidity risk
measures. We should consider new
approaches to help us avert future
shocks in addition to capital-liquidity
connections. For example, probabilistic
approaches, assumptions that take into
‘‘
Looking forward, the industry and
regulators should work together to improve
liquidity risk management in several areas:
and capital risk measures that a firm needs
to manage. These measures should be
considered in an integrated way.
Risk Identification: Liquidity issues and
challenges should be specifically identified
and inventoried as part of the capital
planning exercise to make certain that all
risks are integrated and assessed in the
capital plan.
Regulators and financial institutions need
to keep liquidity risk management moving
forward in a way that balances safety and
soundness with economic growth. We need
to ensure that risk managers have adequate
time to actually manage risk. 
Governance: Specific interrelationships in
oversight, policies, and measurement should
be considered, including connections in
committees, memberships, communication
of actions, consistency in policies and
consideration of risk measures.
Supervisory and financial institution
focus is currently bifurcated between capital and
liquidity risk management. However, it is important
for both regulators and financial institutions to
consider the interconnections between these two
crucial aspects of financial resiliency.
account multiple and idiosyncratic risk
considerations, and approaches that
consider different liquidity buffer levels
based on risk levels all may have potential.
This is both a regulatory and individual
firm challenge: to develop better risk
identification and early warning systems
to monitor idiosyncratic and systemic risks
and proactively address them.
14
Contingency planning: Capital and
liquidity should be considered in a related
way (e.g., governance, early warning signals,
etc.). Both are important elements in
recovery planning.
Risk measurement and management:
As we transition closer to Basel III
implementation, there are multiple liquidity
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Fire Extinguishers
& Smoke Detectors
Macroprudential Policy and
Financial Resiliency
S
 by R
andall S. Kroszner, Professor, University of Chicago
Since the global financial crisis, a debate has emerged about the appropriate role of central banks and their associated
regulatory authorities in financial stability and resiliency. I believe that there are two basic views of the responsibilities:
to act as a fire extinguisher or as a smoke detector.
The classic role of a central bank is to act as a fire extinguisher, focusing on its ability to act as a lender of last resort
and to create liquidity in times of financial stress. This role emphasizes that a central bank should stand ready to act as
the flames of crisis begin to appear. It can then douse them with liquidity to prevent the flames from spreading from
one institution or market to another in order to avoid a system-wide conflagration. In this view, the key responsibility is
to minimize damage once the shock hits, not to foresee and prevent crisis, a goal that has been perceived as too difficult
and potentially politically charged.
In contrast, the smoke detector, or macroprudential, role emphasizes that a central bank has a fundamental
responsibility to act early to prevent the tinder from igniting in the first place. Macroprudential policy focuses on
proactive monitoring of individual institutions and interconnected markets for signs of froth and fragility. The smoke
* Financial support was provided by The Clearing House. This paper draws on earlier work in Kroszner (2011 and 2012).
16
detector role certainly does not conflict with the more
traditional fire extinguisher role but instead significantly
expands the mandate and activities of regulators,
supervisors, and central banks.
Policymakers in the G20 and many other countries
have been seeking a larger smoke detector role for
central banks and regulatory authorities. Rather than
take the probability of a crisis as given, or as driven
primarily by factors beyond policy control, they have
increased the responsibility of central banks and
regulatory authorities to try to reduce the likelihood of
a crisis, not just reduce the costs once the crisis hits. In
this essay, I will provide a brief analysis of some of the
costs and benefits of macroprudential policy and key
challenges ahead.
Objectives and Trade-Offs in
Regulatory Reform
Just as with any regulatory reform, we must articulate
the objectives in order to assess the costs and benefits
of macroprudential policy. The goal of banking and
financial development regulation should be to support
and enhance sustainable economic growth, consistent
with consumer protection that maintains the integrity
of the markets. A large body of research suggests that a
deep and developed financial system is a driving force
behind economic development and growth (see, e.g., the
summaries in Levine 2005 and 2012).
The evidence comes from studies of long-term growth
and development across countries, as well as from studies
looking across U.S. states with changing regulatory
regimes (see Kroszner and Strahan 2014). In the U.S., for
example, deregulation of restrictions on bank branching
within and across states during the 1970s and 1980s is
associated with the development of a more competitive
and robust banking system and more access to credit
for entrepreneurs, which increased the formation of
small businesses. The international research suggests
that well-developed financial systems can be particularly
helpful for those at the lower end of income distribution.
Increasing the efficiency of the allocation of capital to the
highest return projects and giving the less affluent access
to capital that they would not have in a less developed
system appear to be the primary mechanisms for driving
economic growth.
17
Fire Extinguishers & Smoke Detectors: Macroprudential Policy and Financial Resiliency
From a policy perspective we must ask: Could there be
a trade-off between higher growth and higher volatility
or potential for crises? (See Kroszner and Strahan 2011.)
That is, to obtain a higher growth “return” through
financial development, is there a cost in terms of greater
“risk” in the system? Theoretically, greater financial
depth and development could either increase or decrease
stability and resiliency. On the one hand, a larger and
more developed financial sector could improve risk
sharing and diversification and thereby reduce volatility
and increase resiliency. On the other, a larger and
more developed financial sector could allow greater
concentrations of risk and generate interconnections,
thereby potentially making the entire system more fragile
and vulnerable to shocks. Research using pre-crisis data
suggests that in some circumstances a deeper financial
system reduces volatility but in others can contribute to
it (see, e.g., Kroszner 2007, Kroszner et al 2007, Morgan,
Rime, and Strahan 2007, Arcand et al 2012, and Kroszner
and Strahan 2014).
The Role of Macroprudential Policy
Macroprudential policy, thus, should focus on
the circumstances in which financial activities may
contribute to financial fragility and economic volatility.
It is crucial then to assess the potential benefits of greater
stability and resiliency against potential costs in terms of
lower economic growth. A number of recent papers have
attempted to outline such a framework (e.g., Kroszner
and Strahan 2011, International Monetary Fund 2013,
and Bank of England 2014), and policymakers engaged
in financial regulatory reform need to consider both
forces.
To be able to assess the costs and benefits of
macroprudential policy, it is necessary to define as clearly
as possible its scope. The IMF (2013, p. 6), consistent
with the Financial Stability Board and the Bank for
International Settlements, describes macroprudential
policy as “the use of primarily prudential tools to limit
systemic risk. A central element in this definition is
the notion of systemic risk—the risk of disruptions to
the provision of financial services that is caused by an
18
impairment of all or parts of the financial system, and
can cause serious negative consequences for the real
economy.”
This statement reflects a change from the simple fire
extinguisher approach “to clean up the mess afterwards”
with liquidity provision. Traditionally, it was seen as
difficult to predict disruptions and to find precise tools
ex ante to prevent them. This greater sensitivity to and
focus on financial stability concerns is valuable, but
policymakers and market participants should understand
that effective macroprudential policy might not be easy.
Though expanding the toolkit is valuable, I caution
that there are significant challenges to implementing
macroprudential supervision and regulation as an
effective smoke detector, as well as political risks for the
central bank. Excessive faith in macroprudential policy
to stop the buildup of risk concentrations and froth in
markets could lead to reduced market discipline and
forms of moral hazard, so it is important to be realistic
about what macroprudential policy can and cannot
do. I will briefly describe three broad challenges for
macroprudential policy.
Three Broad Challenges for
Macroprudential Policy
The first broad challenge concerns data and
measurement. What will be the metrics or indicators
used to measure the buildup of system-wide risk and
heighted vulnerability to a financial crisis that should
trigger preemptive macroprudential action? Following
the financial and currency crises in emerging markets
in the 1980s and 1990s, academics and researchers at
institutions such as the IMF and World Bank tried to
develop “early warning flags” to better anticipate where
and under what circumstances a crisis might occur. This
exercise proved to be extremely difficult and did not
produce indicators that would reliably “flash yellow” or
“flash red” sufficiently far in advance to allow authorities
to act to avoid trouble.
Since the most recent financial crisis, the Basel
Committee has emphasized rapid credit growth, either in
a specific market or in an economy overall, as a warning
signal. Other measures include rapid increases in asset
prices, unusually compressed risk spreads, increases
in leverage, and reductions in credit underwriting
standards (e.g., Borio and Lowe 2002, Drehmann et al
2011, IMF 2013, and Stein 2014). These are important
indicators that central banks and supervisory authorities
should be monitoring. I applaud the continuing efforts to
refine these “flags” but agree with the IMF (2013, p. 18)
that the systemic risk monitoring framework should be
characterized as a “work in progress.”
Even if a reasonable set of indicators can be developed,
there is a second broad challenge for macroprudential
policy that is more theoretical in nature. How strong
of a foundation can financial economics provide to
supervisors and regulators that an asset is overpriced or
a risk premium is too low? As Larry Summers (1985)
emphasized many years ago, financial economics and
markets are extremely good for ensuring that a 24 ounce
bottle of ketchup is priced at twice as much as a 12 ounce
bottle but not quite as helpful for determining what an
ounce of ketchup should be worth. Assumptions about
preferences, risk aversion, discount rates, liquidity, etc.
are needed, and reasonable people could disagree about
these.
‘‘
Distinguishing between ex ante frothiness that will
end in tears and the dynamics of an evolving market
economy, for example, is not straightforward. Such a
distinction requires two assessments: First, what is the
threshold for one or a combination of these metrics to
flash yellow or flash red? Much valuable research is being
undertaken to try to determine appropriate thresholds,
but we are far from knowing when an economy has
reached a yellow or red zone. Economies in earlier stages
of development, for example, may experience more rapid
credit growth than more developed economies as part
of a balanced “catch-up” growth path as they converge
to the more developed economies. As the IMF (2013,
p. 17) has pointed out, “…not all credit booms end in a
bust, as they may be justified by better fundamentals,
and that loan growth can contribute to a healthy financial
deepening” (see Dell’Ariccia et al, 2012).
In addition, what are the system-wide consequences
if the bubble does burst? (See, e.g., Mishkin 2009.)
Clearly, in a market like housing that involves high
leverage and that is widely used as collateral in lending,
rapid asset price declines can have significant systemwide consequences, as we saw in the most recent global
financial crisis. In contrast, the dramatic declines in asset
values and colossal mark-to-market losses with the end
of the so-called “dotcom bubble” in the early 2000s left
little imprint on the macro-economy and did not trigger
a banking or financial crisis. Also, new markets and
instruments pose particularly vexing problems because,
by their very nature, they have short data trails by which
risks could be assessed.
It is crucial then to assess the
potential benefits of greater stability
and resiliency against potential costs
in terms of lower economic growth.
Without a straightforward and theoretically grounded
way to argue that market pricing is not properly taking a
risk into account, a supervisor or regulator is open to the
criticism of being arbitrary and attempting to substitute
her judgment for those of the market participants who are
putting their own money on the line. It can be difficult for
the supervisor or regulator to prove the case. Unfortunately,
this also opens the way for political judgments and pressures
to determine what is and is not considered “arbitrary.”
The third challenge concerns the political-economy
dynamic. Will a central bank’s (or regulatory authority’s)
independence be challenged if it is actively engaged in
19
Fire Extinguishers & Smoke Detectors: Macroprudential Policy and Financial Resiliency
macroprudential policymaking? Many of the instruments of
macroprudential policy involve increasing the costs of and/
or reducing the availability of credit for particular activities
or to certain sectors. This can bring the central bank or
supervisor into politically charged areas of credit allocation.
Consider the case of housing. The U.S. and many
other countries have numerous government programs
and policies that encourage home ownership, ranging
from reductions in down payments to subsidies, to
securitization (in the U.S., for example, through the
government sponsored enterprises). If a central bank
becomes concerned about frothiness in housing, how
easy would it be to adopt policies that reduce loan
to value ratios, restrict securitization, raise capital
requirements, or otherwise increase the costs of
mortgages? The unelected body of the central bank
could be portrayed as trying to overrule public policies
explicitly adopted by an elected body. This certainly
could put the central bank in the political crosshairs.
Effective macroprudential policies thus may involve risks
for central bank independence and the independence of
supervisors.
With a post-crisis mandate for a broader smoke
detector, macroprudential role, central banks and
associated regulatory authorities need to analyze carefully
the costs and benefits of policy actions. Understanding
the sources of vulnerabilities in the system is crucial
to evaluating where macroprudential policy can be
effective. Assuring sufficient capital through countercyclical capital buffers, for example, is quite sensible,
but determining the precise level of those buffers is
quite difficult. Such policies can be quite valuable but
are a work in progress. We should avoid a false sense of
confidence that these policies can assure stability or that
we have sufficient understanding and experience to fully
comprehend the trade-offs involved. 
References
Arcand, Jean-Louis, Enrico Berkes and Ugo Panizza
(2012). “Too much finance?” IMF Working Paper No.
12/161, Table 2.
Bank of England, 2014.
Borio, Claudio, and Philip Lowe, 2003, “Imbalances
or ‘Bubbles?’ Implications for Monetary and Financial
Stability,” in Asset Price Bubbles, William C. Hunter,
George G. Kaufman, and Michael Pomerleano (eds.),
MIT Press (Cambridge: Massachusetts).
Committee on the Global Financial System, 2012,
“Operationalising the Selection and Application of
Macroprudential Instruments,” CGFS Papers No. 48
(Basel: Committee on the Global Financial System).
Dell’Ariccia, Giovanni, Deniz Igan, Luc Laeven, and Hui
Tong, with Bas Bakker and JeromeVandenbussche,
2012, “Policies for Macrofinancial Stability: How to
Deal with Credit Booms,” IMF Staff Discussion Note
12/06 (Washington: International Monetary Fund).
Drehmann, Mathias, Claudio Borio, and K. Tsatsaronis,
2011, “Anchoring Countercyclical Capital Buffers: The
Role of Credit Aggregates,” International Journal of
Central Banking, Vol. 7, No. 4, December 2011.
International Monetary Fund (IMF), 2013. “Key
Aspects of Macroprudential Policy,” IMF Research
Note, June 2013.
Kroszner, Randall S., “Analyzing and Assessing Banking
Crises,” speech at Federal Reserve Bank of San
20
Francisco, Conference on the Asian Financial Crisis
Revisited, September 6, 2007.
Kroszner, Randall S. “Challenges for Macroprudential
Supervision,” in Macroprudential Regulatory Policies:
The New Road to Financial Stabilty?, Stijn Claessens,
Douglas Evanoff, George Kaufman, and Laura Kodres.,
eds., Hackensack, NJ: World Scientific Publishers,
2011, pp, 379-86.
Kroszner, Randall S. “Stability, Growth, and Regulatory
Reform,” in Financial Stability Review: Public Debt,
Monetary Policy, and Financial Stability, Banque de
France, Paris, April 2012, pp. 87-93.
Kroszner, Randall S. and Strahan, Philip E. “Regulation
and Deregulation of the U.S. Banking Industry:
Causes, Consequences, and Implications for the
Future,” with Philip Strahan, in Nancy Rose, ed.,
Studies in Regulation, Chicago: NBER and University
of Chicago, 2014, pp.485-543.
Kroszner, Randall S. and Robert Shiller. 2011.
Reforming U.S. Financial Regulation: Before and
Beyond Dodd-Frank, Cambridge, MA: MIT Press.
Levine, Ross. 2005. “Finance and Growth: Theory and
Empirics.” In Handbook of Economic Growth, eds.:
Philippe Aghion and Steven N. Durlauf.
Kroszner, Randall S., Luc Laeven, and Daniela
Klingebiel. 2007. “Banking Crises, Financial
Dependence, and Growth.” Journal of Financial
Economics, April, 84(1), 187-228.
Levine, Ross. 2011. “Regulating Finance and
Regulators to Promote Growth,” in Federal Reserve
Bank of Kansas City, Symposium on Achieving
Maximum Long-Run Growth, pp. 271-312.
Kroszner, Randall S. and William Melick, ““The
Response of the Federal Reserve to the Recent
Banking and Financial Crisis” in Jean Pisani-Ferry,
Adam Posen, and Fabrizio Saccomanni, eds., An
Ocean Apart? Comparing Transatlantic Response to
the Financial Crisis, Brussels: Bruegel Institute and
Peterson Institution for International Economics,
2011.
Mishkin, Frederick. 2011. “Monetary Policy Strategy:
Lessons from the Crisis,” in M. Jarocinski, F. Smets, and
C. Thimann (eds.), Monetary Policy Revisited: Lessons
from the Crisis, proceedings of the Sixth ECB Central
Banking Conference, Frankfurt: ECB, pp. 67-118.
Kroszner, Randall S. and Strahan, Philip E. “Financial
Regulatory Reform: Challenges Ahead,” American
Economic Review, Papers and Proceedings, May 2011,
101(3), pp. 242-46,
Stein, Jeremy C. 2014. “Incorporating Financial
Stability Considerations into a Monetary Policy
Framework, Speech at the International Research
Forum on Monetary Policy, Washington, D.C. March
21, 2014.
Summer, Larry. 1985. “On Economics and Finance,”
Journal of Finance, vol 40, no, 3, July, pp. 633-5.
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Financial Stability
Lessons from
the Crisis
S
 by A
ndrew W. Lo, Professor, MIT
Since the Financial Crisis of 2007–2008, macroeconomic modeling has come under fire for the spectacular failure
of macroprudential policies to anticipate the impact of crisis on the real economy. Guided by highly sophisticated
mathematical models known as dynamic stochastic general equilibrium (DSGE) models, central bankers and regulators
had no idea that the financial-market tremors that began as early as 2005 would exact such an enormous toll on real
output and employment just a few years later.
Part of the reason was, of course, the fact that the DSGE models used by central bankers did not contain a financial
sector. From a macroeconomist’s perspective, financial markets are a sideshow, always operating flawlessly and
without constraints to facilitate production, real investment, and economic growth. With the benefit of hindsight, we
now understand that financial constraints can become extraordinarily important when market dislocation strikes.
Apparently, financial stability cannot be taken for granted.
The reaction against DSGE models has been swift, with the most severe critics arising from inside the economics
profession. In his testimony before the U.S. House of Representatives Committee on Science and Technology, MIT
economist and Nobel Laureate Robert Solow leveled the following critique against this literature:1
1
22
Solow (2010, p. 2).
“Especially when it comes to matters as important
as macroeconomics, a mainstream economist like me
insists that every proposition must pass the smell test:
does this really make sense? I do not think that the
currently popular DSGE models pass the smell test.
They take it for granted that the whole economy can be
thought about as if it were a single, consistent person or
dynasty carrying out a rationally designed, long-term
plan, occasionally disturbed by unexpected shocks,
but adapting to them in a rational, consistent way. I do
not think that this picture passes the smell test. The
protagonists of this idea make a claim to respectability
by asserting that it is founded on what we know about
microeconomic behavior, but I think that this claim is
generally phony. The advocates no doubt believe what
they say, but they seem to have stopped sniffing or to
have lost their sense of smell altogether.”
In a surprisingly frank and courageous mea culpa,
Narayana Kocherlakota, President of the Federal Reserve
Bank of Minneapolis, acknowledged the limitations of
macroeconomic theory and policy:2
“I believe that during the last financial crisis,
macroeconomists (and I include myself among them)
failed the country, and indeed the world. In September
2008, central bankers were in desperate need of a
playbook that offered a systematic plan of attack to deal
with fast-evolving circumstances. Macroeconomics
should have been able to provide that playbook. It could
not. Of course, from a longer view, macroeconomists
let policymakers down much earlier, because they
2
Kocherlakota (2010, p. 5).
23
Macroeconomic Modeling and Financial Stability: Lessons from the Crisis
did not provide policymakers with rules to avoid the
circumstances that led to the global financial meltdown.”
A Brief History of Macro Policy
Models
These devastating indictments of a large swath of
modern macroeconomics and policy is hard to square
with all the Nobel prizes awarded to the architects of
the influential DSGE edifice: Lucas, Kyland, Prescott,
Sargent, Sims, and Hansen. Could it be that so many
people were so easily fooled for so long, or has the
pendulum swung too far the other way?
Macroeconomic modeling for policy purposes is
a relatively new endeavor. The Dutch economist Jan
Tinbergen published the first empirical macroeconomic
model of an economy in 1936, intended to forecast the
economic effects of Dutch policy responses to the Great
Depression. However, Tinbergen’s model is more than
a historical footnote. Although his model was primitive
by modern standards, it was the first in a lineage of
macroeconomic forecasting models that are still used
today.3
‘‘
From a macroeconomist’s
perspective, financial markets are a
sideshow, always operating flawlessly
and without constraints to facilitate
production, real investment, and
economic growth.
In this article, I hope to shed some light on this
conundrum by tracing the origins of DSGE models
and asking what lessons we have learned about
macroeconomic modeling from the Financial Crisis.
The superficially damning criticism of the DSGE
framework belies the importance of the notion of general
equilibrium and the Lucas critique to macroeconomic
policy, and may divert attention from the more urgent
task of developing better alternatives for regulators and
policymakers. By examining the historical roots of DSGE
models and studying their strengths and weaknesses
from a financial-markets perspective, we can see a clearer
path for building the next generation of macroeconomic
policy models.
24
Tinbergen’s original approach was ad hoc, without
a strong theoretical basis. Structural relationships
between economic variables were eyeballed from linear
regressions4 on minimal econometric data. Because the
modern system of national accounts was not developed
until after World War II, important macroeconomic
variables were omitted from Tinbergen’s model.
Nevertheless, Tinbergen’s work was striking enough
to form the basis for the first generation of postwar
macroeconomic models.
Following the war, the late Lawrence Klein, then
a young economist with the Cowles Commission,
combined Tinbergen’s framework with elements of
John Maynard Keynes’ macroeconomic theory to model
the prewar American economy.5 Klein’s approach had
two great early successes. His first model successfully
predicted that the end of the war would result in a boom,
not a return to the Depression-era conditions feared
by many policymakers. On the other hand, an updated
model, which Klein developed with Arthur Goldberger,
3
Dhaene and Barten (1989); Tinbergen (1937); Tinbergen (1981).
4
In statistics, a regression analysis is an econometric tool
prominently used for investigating the relationships between
variables. Typically, the investigator seeks to ascertain the causal
effect of one variable for another. This requires that the investigator
assemble data on underlying variables in question and use
regression to determine the approximate quantitative effect of the
causal variables upon the variables they influence. Investigators
generally assess the degree to which the regression instills
confidence in the results by assessing “statistical significance.”
5
Klein (1950).
predicted that the Korean conflict would end in a
recession, which also came to pass.6
These predictive successes, made against prevailing
economic opinion, cemented Klein’s approach in the
minds of economists and policymakers alike. Klein’s
models were theoretically and statistically much
more sophisticated than Tinbergen’s early efforts, and
correspondingly more influential. In the late 1960s,
Klein’s ambitious Brookings model inspired the Federal
Reserve Board to develop its own macroeconomic
model to use in forecasting and policy analysis.7 Franco
Modigliani of MIT, Albert Ando of the University of
Pennsylvania, and Frank de Leeuw of the Federal Reserve
Board led the project to develop the MPS model (an
acronym for MIT/Pennsylvania/SSRC, which funded
Ando), which the Fed used from 1970 to 1995.
A hallmark of the Tinbergen-Klein school of modeling
was the use of a multitude of empirically derived
behavioral equations to specify relationships between
macroeconomic variables. For example, the original
MPS model had sixty behavioral equations, a third
of them having to do with the housing and mortgage
market. Unexpected macroeconomic events, such as
the oil shocks of the 1970s, induced modelers to add
highly specific equations to model previously unforeseen
linkages, such as ones for domestic coal consumption, or
dummy variables for automobile and dock strikes.8
However, one macroeconomic event of the 1970s
struck at the heart of the modelers’ basic assumptions.
Most of these models included the inverse relationship
between unemployment and inflation known as the
Phillips curve.9 Although this was an empirical result,
it fit the Keynesian macroeconomic framework very
well, and the Phillips curve quickly became part of
the standard toolkit of the postwar generation of
macroeconomists.
6
Klein and Goldberger (1955).
7
Brayton et al (1997).
8
Brayton and Mauskopf (1985).
9
Phillips (1958).
Unfortunately, the American economy during the
1970s demonstrated that Phillips curve was not an
immutable natural law at all, but an apparent statistical
fluke. The 1970s were a time of stagflation, stagnant
economic growth and high inflation. Rising inflation did
nothing to alleviate high unemployment in the 1970s.
Central bankers who relied too much on expanding
the money supply to stimulate the economy found
themselves stimulating inflation instead.
Enter the Lucas Critique
The collapse of the Phillips curve, and the apparent
failure of Keynesian macroeconomics to predict it,
became an important battleground in the rational
expectations revolution of the next decade. Robert Lucas
was foremost among these intellectual combatants. His
key insight, first published in 1976, was that economic
modelers had no privileged insights into the functioning
of the economy that the market did not already share.
In fact, according to Lucas, the more successful an
economic model was in the short run, the more likely
it would fail in the long run. This stochastic drift in the
quality of long-term prediction was the consequence
of economic agents taking into account the changes
suggested by the models. Standard econometric models
failed in the long run precisely because people adapted to
new economic conditions.10
This paradox became known as the Lucas critique,
and it represented an existential threat to the entire
postwar program of economic modeling. Any model
that narrowly used historical macroeconomic data to
evaluate policy was, according to Lucas, flawed at its
foundation. Lucas was well aware that his conclusion was
“destructive,” almost nihilistic, but he offered economists
a way out from this dilemma. A macroeconomic model,
to escape the Lucas critique, should consist of economic
agents responding to policy changes or outside shocks
according to their economic preferences. These agents
would then adapt to change by following their economic
self-interest. This type of model, Lucas believed, with
10 Lucas (1976).
25
strong microfoundations based on the preferences of the
agents themselves, rather than on empirical relationships
between macroeconomic variables, would be able to
avoid the problems of his critique.
The Birth of DSGE
The DSGE model satisfied Lucas’s criteria. Within a
forward-looking, rational expectations framework, a
DSGE model was populated by agents that optimized
their economic choices according to their preferences,
in order to find a full equilibrium solution to the general
(albeit simplified) economy. Rather than focusing
on static snapshots of the economy, a DSGE model
allowed economic variables to change dynamically
over time in a logically consistent manner. A DSGE
model could also respond to random stochastic shocks,
such as fluctuations in prices like the oil shocks of the
1970s, changes in policymaking, or the adoption of
new technologies by economic agents. In theory, this
flexibility allowed a DSGE model to be used in previously
unencountered economic conditions, without having
to specify new relationships in the manner of earlier
macroeconomic forecasting models.
DSGE models were originally associated with real
business cycle (RBC) theory, which held that expansions
and recessions in an economy were principally the result
of outside shocks rather than changes in money supply
or aggregate demand. In 1982, Finn Kydland and Edward
C. Prescott found that a simple growth model, when
fitted into a DSGE framework, could fit the business
cycles of the postwar United States rather well. According
to Kydland and Prescott’s model, technology shocks
in the postwar period accounted for half the ‘action’
in U.S. business cycles. 11 For many macroeconomists,
the success of Kydland-Prescott and its follow-ups
validated RBC theory. Older schools of macroeconomic
thought, such as classic Keynesianism or monetarism,
were seen as fundamentally flawed since they could
not be formulated in terms of microfoundations with
optimizing agents.
These early DSGE models left little room for the
traditional role of fiscal and monetary policy to guide
an economy. In part, this represented the modelers’
tendency to shave with Occam’s razor. If the inclusion of
money or a financial sector in a model was not necessary
to describe the data, they shaved it off. For many,
however, this modeling decision was due to skepticism
about the role of a central bank or a government in a
macroeconomy. If one believes the business cycle is
caused by technological shocks, as in RBC theory, one
will downplay the role of central bank intervention in
mediating the business cycle. Nevertheless, an opposing
school, the New Keynesians, began using the DSGE
microfoundational framework while incorporating
Keynesian concepts such as wage and price stickiness to
model the macroeconomy, allowing greater room for the
role of government stabilization in these models.
Academic macroeconomic modeling diverged from
the models used by policymakers for a generation. For
example, the Federal Reserve Board’s current model of
the U.S. economy, called FRB/US, was adopted in 1995,
but it is still of the highly parameterized Tinbergen-Klein
lineage. Its developers conceded the importance of the
Lucas critique, but they did not consider it foundational.
As a result, FRB/US allows the modeler to use rational
expectations, but as a secondary option in forecasting.
One can direct an agent to use model-consistent future
expectations, in the manner of a rational expectations
model, or to limit and lag what knowledge is available to
the agent.12
DSGE Goes Abroad
However, the continued success and increasing
sophistication of DSGE models in academia caused
policymakers to take a second look at their usefulness.
In 2003, the European Central Bank (ECB) released its
influential DSGE model of the eurozone, devised by
Frank Smets of the ECB and Raf Wouters of the National
Bank of Belgium.13 In its original form, Smets-Wouters
12 Brayton, Laubach, and Reifschneider (2014).
11 Kydland and Prescott (1982).
26
13 Smets and Wouters (2003).
operated at a very high level of abstraction. It did not
model individual countries or regions or markets or
industries within the eurozone. As in many earlier DSGE
models, Smets-Wouters also did not incorporate an
explicit role for money and financial markets. Rather,
it included a “Taylor rule” to simulate the behavior of a
central bank. Meanwhile, the role of the government in
Smets-Wouters was quite simple: it had the power to tax
and the power to adjust interest rates.
model, commissioned its SIGMA model for use in policy
analysis in 2006.18 By 2008, the macroeconomist Michael
Woodford could tell his colleagues at the January annual
meeting of the American Economics Association, “It is
now accepted that macroeconomic models should be
general equilibrium models.”19
‘‘
Despite these deficiencies, the Smets-Wouters
model was considered a success. Smets-Wouters fit
the historical macroeconomic data of the eurozone
well, including gross domestic product, consumption,
investment, wages, employment, and short-term interest
rates. Moreover, it outperformed vector autoregression
models on the same data. With a very small number
of variables, Smets-Wouters managed to describe the
macroeconomic behavior of one of the most complicated
economic regions in the world—and it did so better than
its competition.
The Smets-Wouters model would become a workhorse
for the ECB. Smets-Wouters was simpler and apparently
more powerful than the highly specified, almost baroque
models of the Tinbergen-Klein tradition. It used the
fundamental economic principle that agents would
always try to optimize their behavior, subject to their
constraints and preferences, to overcome the Lucas
critique. Other central banks and international financial
institutions quickly followed the ECB in adopting DSGE
models for policy use: the International Monetary
Fund and its Global Economic Model (GEM)14; the
Bank of England Quarterly Model (BEQM)15; the Bank
of Canada and its Terms of Trade Economic Model
(ToTEM)16; and the Riksbank Aggregate Macromodel
for Studies of the Economy of Sweden (RAMSES).17 Even
the Federal Reserve Board of the United States, with
its fantastically detailed, institutionally tested FRB/US
14 Bayoumi (2004).
Macroeconomic risks must
be modeled more accurately and
monitored more regularly, and
traditional macroeconomic forecasting
models may simply lack the necessary
resolution to capture modern financial
crises in the making.
DSGE Models and the Financial
Crisis
Macroeconomic crises have consistently inspired
economists to create new predictive models. The Great
Depression motivated Jan Tinbergen to invent a new
form of macroeconomic model from scratch, while
World War II impelled Lawrence Klein to synthesize
Tinbergen and Keynes to create a new school of
macroeconomic modeling. The macroeconomic crises
of the 1970s made Robert Lucas’s critique of those
models urgent and compelling, while Lucas’s insights
into rational expectations made the new paradigm of the
DSGE model possible. Perhaps necessity is indeed the
mother of invention.
15 Harrison et al (2005).
16 Murchison and Rennison (2006).
18 Erceg et al (2006).
17 Adolfson et al (2007).
19 Woodford (2009).
27
Today we live in the aftermath of the worst global
financial crisis since the Great Depression. No economic
model predicted the crisis or its extent beforehand.
However, DSGE models came under especially harsh
criticism, since many models then in use were too weakly
specified to be useful for policymakers in a financial
crisis. The financial crisis was transmitted through
structural linkages of a sort omitted as unnecessary
by DSGE modelers. Some DSGE models omitted a
financial sector entirely. While other DSGE models did
incorporate financial frictions, the complex range and
rich variety of financial instruments were reduced to
one or two assets trading in a single market. The many
possible roles of a monetary authority were usually
simulated by a simple Taylor rule on the interest rate.
The crisis had widely different effects among populations
with different financial characteristics, such as wealth
and income; however, some DSGE models avoided this
heterogeneity as too difficult to calculate, in favor of
unitary agents representing, e.g., all the households in
the economy. 20
‘‘
The financial crisis was transmitted
through structural linkages of a sort
omitted as unnecessary by DSGE
modelers. Some DSGE models omitted
a financial sector entirely.
28
with rational expectations. For example, unemployment
can be included in a DSGE model, but the premises of
the DSGE framework imply that the optimizing agent
somehow prefers being unemployed. DSGE models rely
on exogenous shocks to drive significant changes in the
macroeconomy, but these shocks—to the technological
frontier, to the depreciation rate, to the labor market’s
willingness to work—made little contextual sense. To
quote Narayana Kocherlakota, “Why should everyone want
to work less in the fourth quarter of 2009? What exactly
caused a widespread decline in technological efficiency in
the 1930s?”21 However, in the aftermath of the financial
crisis and its illustration of “the madness of crowds,” it
was the impossibility of irrational behavior within DSGE
models that struck many critics as a fatal flaw.
The Future of DSGE
Just as the Depression and its aftermath inspired
Tinbergen and Klein, and the crises of the 1970s
inspired Lucas, Kydland, and Prescott, the current
macroeconomic moment now appears ripe for a shift
in how we think about modeling the economy. One
approach, which appears to have been adopted by the
Federal Reserve Board, is to downplay the importance
of the Lucas critique in macroeconomic modeling, as
witnessed by its aggressive use of the FRB/US model
in policy analysis. However, most macroeconomists
believe that the Lucas critique still holds, and that
strong microfoundations are a necessity for a successful
macroeconomic model. Kocherlakota (2010) presents
an eloquent and inspiring overview of the current state
of macroeconomics and several promising directions for
the future. Let me add to his vision by suggesting two
incremental shifts, and one radical shift in how we might
approach this challenge.
Another critique of DSGE models that emerged after
the crisis regarded their lack of behavioral realism.
Important economic phenomena, such as unemployment
and asset bubbles, were harder to understand within a
DSGE framework, which assumed optimizing agents
The first shift is to take risk seriously in
macroeconomic models and incorporate individual,
institutional, and regulatory responses to changing
risks—both real and perceived—in their decisions.
We measure many aspects of our macroeconomy
20 Kocherlakota (2010), pp. 12-16.
21 Kocherlakota (2010), p. 16
Capital strength
is the foundation of our success
At UBS, we are proud of our financial strength, having achieved a 13.7%*
Swiss SRB Basel III CET1 capital ratio in 3Q14—the highest among our peers.
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© UBS 2014. All rights reserved.
29
such as inflation, output, and unemployment but we
currently have no measure of aggregate risk in the
economy. Macroeconomic risks must be modeled more
accurately and monitored more regularly, and traditional
macroeconomic forecasting models may simply lack the
necessary resolution to capture modern financial crises
in the making. A broader set of measures, including
those that focused on patterns in financial linkages, may
be more appropriate to act as early warning indicators.22
These risk models would complement standard
macroeconomic forecasts the way the National Weather
Service provides real-time monitoring and active alerts—
hurricanes, tornadoes, and floods cannot be legislated
away but our early warning system has greatly reduced
property damage and the number of lives lost.
The second shift is to incorporate the financial sector
more fully into existing DSGE models. It may be that the
financial crisis simply came too soon in the development
of DSGE modeling for it to have reached its full utility.
One promising approach, following Simon Gilchrist,
has been to introduce a financial accelerator to amplify
the effect of shocks to the credit market on the general
economy.23 A calibrated DSGE model that includes
the financial accelerator can successfully account for
the overall drop in economic activity during the crisis
period, as well as the dramatic increase in credit spreads.
A richer, more robust description of financial markets is
needed.
The third shift, and the most radical, is to reexamine
the microfoundations of the DSGE model. Instead of
agents that optimize their behavior according to rational
expectations, we should consider agents with predictable
irrationalities in their behavior—investor psychology,
for example. Just as the optimizing behavior and rational
expectations of agents in a standard DSGE model are
analogous to the Efficient Markets Hypothesis, the
adaptive behavior of agents in this variation have their
parallels in the Adaptive Markets Hypothesis.24 These
22 Billio, Getmansky, Lo, and Pelizzon (2012), Bisias, Flood, Lo,
Valavanis (2012).
23 Gilchrist and Zakrajšek (2011).
24 Lo (2004, 2012).
30
agents would fulfill the spirit of the Lucas critique by
adapting to economic circumstance, not necessarily in an
optimal way, but subject to the past environment of the
agent.
Macroeconomic models need to take into account
Keynes’ infamous animal spirits as well as economic
rationality. The assumption that aggregate behavior in
an economy is approximated by optimizing, forwardlooking behavior should have been put to rest by the
Financial Crisis, if not the housing bubble, or the dotcom bubble, or the Dutch tulip bubble in the mid-1600s.
Optimization holds one great virtue for the modeler:
it is mathematically precise. However, complexity and
psychology are two sides of the same coin. Can the full
complexity of the macroeconomy be captured in the
behavior of precise optimizing agents, or will disasters
like the recent crisis continue to emerge just beyond
the grasp of our models? When Albert Einstein was
criticized for the complexity of his theory of relativity,
he responded that “A theory should be as simple as
possible, but no simpler.” The same applies to theories of
the macroeconomy. We may discover, as Keynes did over
half a century ago, that from a policy perspective, being
precisely wrong is not as helpful as being approximately
right.25 
25 Research Support from the MIT Laboratory for Financial
Engineering is gratefully acknowledged. I thank Bob Chakravorti
and Clark Peterson for helpful comments and Jayna Cummings
and Carlos Yu for editorial and research assistance. The views and
opinions expressed in this article are those of the authors only,
and do not necessarily represent the views and opinions of any
institution or agency, any of their affiliates or employees, or any of
the individuals acknowledged above.
References
Adolfson, Malin, Stefan Laséen, Jesper Lindé, and
Mattias Villani. 2007. “RAMSES: A New General
Equilibrium Model for Monetary Policy Analysis.”
Sveriges Riksbank Economic Review 2, 5-40.
Bayoumi, Tamim. 2004. GEM: A New International
Macroeconomic Model. Washington, D.C.:
International Monetary Fund.
Billio, Monica, Mila Getmansky, Andrew W. Lo, and
Loriana Pelizzon. 2012. “Econometric measures of
connectedness and systemic risk in the finance and
insurance sectors.” Journal of Financial Economics
104, 535–559.
Bisias, Dimitrios, Mark Flood, Andrew W. Lo, and
Stavros Valavanis, 2012. “A survey of systemic risk
analytics.” Annual Review of Financial Economics 4,
255–296.
Dhaene, Geert and Anton P. Barren. 1989. “When
it all began: The 1936 Tinbergen model revisited.”
Economic Modelling 6, 203-219.
Erceg, Christopher J., Luca Guerrieri, and Christopher
Gust. 2006. “SIGMA: a new open economy model
for policy analysis.” International Journal of Central
Banking 2, 111-144.
Gilchrist, Simon and Egon Zakrajšek. 2011. “Monetary
Policy and Credit Supply Shocks.” IMF Economic
Review 59, 195–232.
Harrison, Richard, Kalin Nikolov, Meghan Quinn,
Gareth Ramsay, Alasdair Scott and Ryland Thomas.
2005. Bank of England Quarterly Model. London:
Bank of England.
Klein, Lawrence Robert. 1950. Economic Fluctuations
in the United States, 1921-1941. New York: Wiley.
Brayton, Flint and Eileen Mauskopf. 1985. “The
Federal Reserve Board MPS quarterly econometric
model of the US economy.” Economic Modeling 2,
170-292.
Klein, Lawrence Robert, and Arthur Stanley Goldberger.
1955. An Econometric model of the United States
1929-1952. Amsterdam: North-Holland Publishing
Company.
Brayton, Flint, Andrew Levin, Ralph Tryon, and John
C. Williams. 1997. “The evolution of macro models
at the Federal Reserve Board.” Carnegie-Rochester
Conference Series on Public Policy 47, 43-81.
Kocherlakota, Narayana. 2010. “Modern
Macroeconomic Models as Tools for Economic Policy.”
The Region (May), 5–21.
Brayton, Flint, Thomas Laubach, and David
Reifschneider. 2014. “The FRB/US Model: A Tool
for Macroeconomic Policy Analysis.” FEDS Notes.
http://www.federalreserve.gov/econresdata/notes/
feds-notes/2014/a-tool-for-macroeconomic-policyanalysis.html
Lo, Andrew W. 2012. “Adaptive Markets and the New
World Order.” Financial Analysts Journal 68, 18–29.
Lucas, Robert E. 1976. “Econometric policy
evaluation: a critique.” Carnegie-Rochester Conference
Series on Public Policy 1, 19-46.
Murchison, Stephen and Andrew Rennison. 2006.
“ToTEM: The Bank of Canada’s new quarterly
projection model.” Bank of Canada Technical Report
No. 97.
Phillips, A. W. 1958. “The relation between
unemployment and the rate of change of money wage
rates in the United Kingdom, 1861-1957.” Economica
25, 283-299.
Smets, Frank and Raf Wouters. 2003. “An estimated
dynamic stochastic general equilibrium model of
the euro area.” Journal of the European Economic
Association 1, 1123-1175.
Solow, Robert M. 2010. “Building a Science of
Economics for the Real World.” Prepared Statement
for House Committee on Science and Technology,
Subcommittee on Investigations and Oversight.
Tinbergen, Jan. 1937. An Econometric Approach to
Business Cycle Problems. Paris: Hermann.
Kydland, Finn E. and Edward C. Prescott. 1982. “Time
to build and aggregate fluctuations.” Econometrica 50,
1345-1370.
Tinbergen, Jan. 1981. “The Use of Models: Experience
and Prospects.” American Economic Review 77,
17-22.
Lo, Andrew W. 2004. “The Adaptive Markets
Hypothesis.” Journal of Portfolio Management 30,
15–29.
Woodford, Michael. 2009. “Convergence in
Macroeconomics: Elements of the New Synthesis.”
American Economic Journal: Macroeconomics 1,
267-279.
31
State of Banking
Paul Saltzman interviews Bank of America Chairman and CEO Brian
Moynihan, who discusses the opportunities facing the banking industry,
his new role as Chairman of The Clearing House, and the implications of
technology growth on cybersecurity, payments, and bank business models.
Brian, congratulations on becoming the 78th Chairman
of The Clearing House. Let’s start with some big questions.
What are the opportunities facing the banking industry
today and how can they be achieved?
The opportunity is to deliver on what our customers
and clients need and help make their financial lives
better. As an industry, we’ve made progress over the
past several years to become less complex, to get rid
of activity that wasn’t really serving customers, and to
focus on what our customers really want. By being more
straightforward and better serving our customers, there’s
a lot of opportunity for growth.
What are your thoughts about the role of The Clearing
House in our industry, and what’s on your agenda as
chairman for 2015?
The Clearing House serves an important role providing
substantive information and rigorous analysis of issues
to help policymakers make informed decisions, and
that’s something I know will continue. In addition, the
work The Clearing House is doing to help drive the
32
digital economy is important as our industry continues
to improve the customer experience around payments.
Building a real-time payment system will provide a level
of convenience and security our customers want and
that’s one goal I hope we can make progress on this next
year.
When you look around the world for economic growth,
the U.S. looks to be in pretty good shape right now. When
it comes to global and U.S. growth, what are some bright
spots that you see, and what are some of the things that
concern you?
Globally, there is variation by region in terms of
growth, but our experts say that, on the whole, GDP
looks likely to finish slightly higher than last year at
3.1%. In the U.S., the good news is that underlying
growth has continued to improve. The housing recovery
remains on track, albeit gradual, job growth remains
solid, and the corporate sector is in good health with
strong balance sheets. As a company, we serve one in
two American households, so we have good insight on
the consumer, and the data has been pretty consistent.
Brian Moynihan
Chairman and Chief Executive Officer
of Bank of America Corp.
‘‘
As an industry, we’ve made
progress over the past several
years to become less complex,
to get rid of activity that wasn’t
really serving customers,
and to focus on what our
customers really want.
33
State of Banking
Spending is up about 5% from last year and the drop in
gas prices will be a further boost. So, there is a lot to be
optimistic about.
On a related point, what concerns you about
maintaining the safety and soundness of the payments
system?
In many of these interviews, we talk a lot about
leadership and how important leadership is in a unique
industry like banking. Tell me a little bit about your views
on leadership from your time leading Bank of America
through some challenging times.
As the payments system has changed – from cash to
checks to credit cards to digital – security continues to
be the industry’s first priority. What’s encouraging is
that the system gets more secure with more innovation
and technical advancement. The EMV and tokenization
technology are good examples, and we’re always working
on ways to improve.
It was important that we set a clear strategy – a
strategy that we are going to be customer-driven in
everything we do and if we were in activities that
customers did not need us to be in, we aren’t going to
do it. You set that strategy and then empower the team
to drive and deliver it. Banking is all about people – so
equally important is creating a culture of diversity and
inclusion where everyone feels they can succeed. Taking
care of your employees, empowering your team and
having a clear strategy – all of that is leading to better
outcomes for the customers and clients we serve and
better results for our shareholders.
Technology is changing banking and payments as it
has done in so many other industries. We’re doing things
from our phones that only a few years ago required a
trip to a branch. At the same time, though, banking is a
relationship business and a trust business. How can banks
build and maintain brands when channels are becoming
digitized?
Our company has one of the largest digital banking
platforms with 30 million online banking customers
and more than 16 million mobile banking customers.
The number of new mobile customers is growing
at a rate of 195,000 per month. Even so, branches
remain important because banking is still very much a
relationship business. The change in customer behavior
and greater acceptance of technology has enabled us to
optimize our banking centers. For instance, we have put
more specialists in the banking centers: small business
bankers, mortgage loan officers and financial services
advisors, to help customers with more complex financial
needs and to build on the relationships.
34
The next question, of course, has to do with
cybersecurity—just a huge issue that’s being discussed at
the very highest levels of government and industry. Where
are we at on this issue, and where are we going, as both an
industry and as a nation?
We live so much of our lives digitally now –
cybersecurity is mission critical, not just for us, but
for most companies operating in the world today, and
certainly for our customers and clients, too. Our job is
to commit the talent and resources necessary to make
our systems as secure and resilient as we can so that
we can all continue to do business with confidence,
whether in our local communities or around the world.
We are working with partners across industries and
governments to build on that commitment.
What’s your strategy for Bank of America in five or ten
years? What changes, and what stays the same?
We have a clear purpose to help make financial lives
better for those we serve, through the power of every
connection we can help them make. That purpose
has guided us over the past several years to make our
company simpler, stronger, and more customer-focused.
Our strategy is to connect all the capabilities we have
and deliver the breadth of that to every single customer
to help them achieve their goals. And, I believe that
strategy will be the same five, ten, fifty years from now.
How we deliver products may change based on customer
preferences and needs but the fundamental customerfocused strategy will remain the same. 
IMPACT
THROUGH
SPECIALIZATION
Oliver Wyman is a global leader in
management consulting that combines
deep industry knowledge with
specialized expertise in strategy,
operations, risk management, and
organization transformation.
Visit us at www.oliverwyman.com
35
Too Much of a
Good Thing
The Implications of Higher Bank
B
 by A
lexey Levkov, Senior Vice President, and
Clark Peterson, Senior Vice President, The Clearing House
Bank equity capital is critical to maintaining a safe and sound financial position. It is the difference between a bank’s
assets and its liabilities and is a funding source that acts as a financial cushion to absorb unexpected losses at times of
distress. Beyond being a cushion, capital creates a strong incentive to manage a bank in a prudent manner because bank
shareholders are at risk in the event of a failure.
The case for imposing capital requirements on banks rests on externalities associated with bank failure. In
particular, a failure of a large bank has systemic costs that are not fully borne by the bank. These costs, among others,
include disruptions in the financial markets, system-wide reduction in asset values, and losses among other market
participants. The regulator’s task, through mandating higher capital requirements, is to make banks internalize the
systemic costs of their potential failure and buffer the financial sector from the resulting systemic losses.
In this article we analyze the costs associated with changes in capital requirements. We distinguish between equity
capital and debt capital and discuss both the private and social cost of requiring banks to hold additional equity capital.
In the first part of the article we discuss the cost implications of changes in the mix of equity and debt. In the second
part we consider how heightened capital requirements may affect allocation of credit in the economy with potential
implications for financial stability and bank intermediation activities.
36
Our main conclusion is that when abstracting from the
stylized theoretical framework, funding bank activities
with equity is more expensive relative to debt. We should
note that it’s certainly the case that bank equity levels
can be too low. In this case, more equity would enhance
market perceptions of bank safety, lower cost of capital
and likely result in greater credit extension. But our
read of academic literature suggests that substantial
increases in equity capital requirements, both in the U.S.
and elsewhere, result in reduced lending and economic
growth and pushes some borrowers to seek credit from
less regulated sources.
This leads us to two policy recommendations. First, we
encourage policymakers to balance the costs and benefits
of higher capital requirements (Posner, 2014), taking
into account the close link between financial stability and
economic growth (Rosengren, 2011; Hanson, Kashyap,
and Stein, 2011). Second, capital calibrations should
incorporate various banking activities that are vital
for economic growth, not just the probability of bank
failure, thus emphasizing the macroprudential aspects
of financial regulation (Hirtle, Schuermann, and Stiroh,
2009).
Capital Structure and the
Cost of Capital
At the firm level, the debate over bank equity
capital requirements comes down to capital structure.
Managers must make choices about how best to
finance their assets. Broadly speaking, banks finance
their assets with a mix of debt (and deposits, a form
of debt) and equity, all of which are claims to the
firm’s assets. Banks secure financing in the context of
competitive and economic forces, as well as regulatory
requirements. Capital structure choices have significant
trade-offs for companies in general and for banks in
particular.
Debt and equity are both sources of financing, or
capital, but in the banking industry context “capital” is
shorthand to refer to the firm’s equity capital. Equity is a
(residual) ownership claim to a firm’s assets that adjusts
in value depending on the value of cash flows that a
company is able to generate from its assets. Leverage,
or debt capital, involves the substitution of fixed cost
debt for the residual claim of owner’s equity. Leverage
increases expected return and it increases risk. Leverage
37
net impact on Rtax OE rdate, epends n the bcank’s psrofitability, tax rate, aeturn. nd existing cap
choices can relationship hat Alt everage n operat
The net impact on ROE depends n the bThe profitability, aind eoxisting tructure. In aoddition tank’s o expecting a return, equity nvestors nd creditors incur a impact cost tw
hen they fainance choices can impact that return. At aan oapital perating level, the bretween an
equity (ROE) depends a number of pfactor
(ROE) depends a no
umber factors.they Higher leverage will increase iould nterest ayme
business’s assets. This ctequity ost relates to he orn isk f the oiaf nvestors ssets are financing. Ton hey cost earn r
addition o expecting a rteturn, equity and careditors incur a tche h
decrease on assets. Bfirms ut w
it hen w
ill atlso
In addition to expecting a return, equity In investors and incur aa cssets. ost wBut hen hey finance will cdreditors ecrease return on it wtill also dwill ecrease t axes raeturn nd increase leverag
other investments with similar risk profiles. This pportunity cost ciomprises the minimum rate et mpact OE epends on tThe bank
aThe his caost elates to oTtohe risk of tThe he anssets tthey aRre fdinancing. hey c
nCapital
et iT
ore n RfrOE depends n the ank’s ax oo
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business’s ssets. cost relates o the business’s risk of ofthe assets. ssets tmpact hey inancing. hey cbould eprofitability, arn returns n Too aMuch
ofTahis Good
Thing:
ThetImplications
Higher
Requirements
the business n
eeds t
o e
arn o
n i
ts a
ssets t
o m
eet t
he d
emands o
f i
ts d
ebt a
nd e
quity i
nvestors. other investments with similar risk ptrofiles. This oIn pportunity cost comprises the m
inT
other investments with similar risk profiles. This opportunity ost comprises he minimum raate f rteturn o expecting return, equity In addition tco expecting a return, equity investors addition nd o
creditors incur a ac ost when they ifnve
ina
firm’s cost othe f capital. usiness eeds tao odn its arand ssets to minvestors. f his ifts debt aTnd ecquity assets. cost relates to tould he risk
the business needs to earn on its assets to mbeet the business’s dnemands oef arn its ebt equity This s the ssets. This cost elates to the reet isk otbusiness’s f he the daemands ssets tihey aoTre inancing. hey e
other i
nvestments w
ith s
imilar r
isk p
rofiles. firm’s c
ost o
f c
apital. other i
nvestments w
ith s
imilar r
isk p
rofiles. T
his o
pportunity c
ost c
omprises t
he m
inimum firm’s cost o
f c
apital. allows a firm to create multiple
risk-returnccombinations
debt and
equity—
A company’s ost of capital is particular
known atype
s its ofWcapital—both
eighted Average Cost of Capital, or WACC. It states
1
the business needs to earn on its assets to m
the business needs to earn on its assets to meet the demands of its debt and equity investo
from any particular set of assets
(Higginso2011).
weighted
byctheir
in the company’s
company’s verall cost firm’s of ost capital ics apital. the oproportion
f each particular type ocapital
f ocf apital—both debt and eq
firm’s capital. A c
ompany’s of ocf C
apital if s ost kapital, nown aos iW
ts Weighted Acost verage cost A company’s cost of capital is known as its Weighted Acverage ost o
C
r ACC. I
t s
tates that a Cost of Capital, or WA
structure:
weighted by their proportion icn ost the company’s apital company’s of cf apital iis s tkche cost sotructure: f Weeighted ach pearticular type o
f capital—both company’s cost of ocf apital is ko
nown as its company’s overall cost of bycapital he cofost of eon
ach oA pverall articular capital—both aA nd company’s tcype ost oo
cf apital nown as idts ebt Aquity—
verage Cost Capital, r WACC. It W
s
Banks
create
value
earningis atrate
return
company’s o
verall c
ost o
f c
apital i
s t
he c
ost weighted b
y t
heir p
roportion i
n t
he c
ompany’s c
apital s
tructure: !
!
company’s o
verall c
ost o
f c
apital i
s t
he c
ost o
f e
ach p
articular t
ype o
f c
apital—both d
ebt a
n
weighted b
y t
heir p
roportion i
n t
he c
ompany’s c
apital s
tructure: their assets for equity holders,
structure
and capital
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = 𝐾𝐾! (
) + 𝐾𝐾! ( weighted ) by their p roportion in the compan
!!!
!!!capital structure: weighted b
y t
heir p
roportion i
n t
he c
ompany’s choices can impact that return. At an operating level,
!
!
! 𝐾𝐾 on
( ! ) 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊 = 𝐾𝐾! ( !) + 𝐾𝐾! ( ! ) relationship
leverage
𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊
= (
) +
𝐾𝐾
the
between
and
return
equity
!!!
!!!
!
!
! ) times 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊
= 𝐾𝐾
the proport
This formula tells !!!
us that is = its ( 𝐾𝐾
a company’s cost of capital 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊
𝐾𝐾c!ost ( o) f +e
𝐾𝐾quity !!!
! (!!! ) !!!
(ROE) depends on a number of factors.1 Higher leverage
!This formula tells us that a company’s cost of capital is
) plus the c cost ocf ost debt (co𝐾𝐾apital ) times the poroportion f d! ) ebt n pro
toht
equity in its This capital structure ( s that times tells equity
f proportion
s ost ouef s quity ethat quity (o 𝐾𝐾
This fiormula tf ells a( 𝐾𝐾
company’s ciost the ormula toells s ctompany’s hat a(( 𝐾𝐾
ompany’s cost f apital is ts cco
ost f !!!
will increase
whichcwill
cost
the
ofiits equity
in
times tohe p!croportion This formula tells uinterest
s that payments,
a company’s ost decrease
of fcormula apital This is ifts cuits
ost f of
eauquity ! ) times ! )) times
!
!
!
!
) plus he o
increase n i(((ts capital !
pplus
ost debt tquity he the proportion orf equ
dtebt
n its
its cow apital return
assets.
But it willstructure(
taxes
capital
debt
) (pilus tlus he otthe
che 𝐾𝐾apital ) t imes tiimes roportion capital shtructure ( proportion ). Tand
o in uoinderstand a structure
dstructure ecrease n ))l everage ooequity r f oof
aidf n n ihe n setructure cp(!!!
apital !!))times
) plus !!!
tequity he cost f ts dequity ebt (i𝐾𝐾
f ost dccost
ebt tebt c𝐾𝐾
equity in its con
apital structure ( also decrease
!!! !!!
! ) times the !
!!!
!proportion of debt in the capital structure
). Tn o increase understand how ac apital decrea
increase
the firms leverage multiplier. The net impact structure(
). To
). To understand a sdtability, ecrease structure(
or in h
equity !!!
!
will affect loans rates, c!redit ethe
xtension, and financial wleverage e m(ust ow hose structure(
). To u!!!
nderstand how ahquity ow decrease in irn leverage our anderstand an increase in etquity c
structure(
). T
o u
nderstand h
ow a
d
ecrease i
n l
everage o
r a
n i
ncrease i
n e
c
apital equirements !!!
on ROE
understand
how
a decrease
in aleverage
oraan
increase
in
will ffect loans wrates, credit extension, and !!! depends on the bank’s profitability, tax rate, and
will a
ffect l
oans r
ates, c
redit e
xtension, nd f
inancial s
tability, e m
ust u
nderstand h
ow t
h
impact a bank’s W
ACC. rates, credit extension, and financial stability, we must understand h
ffect loans ahanges bank’s WACC. existing
capital
structure
2011).
capital
will
affect
loanscrates,
credit
will affect loans rates, credit (Handorf
extension, awill nd fainancial stability, we ust requirements
how timpact hose impact a equity
bank’s Wm
ACC. understand impact a bank’s Wextension,
ACC. and financial stability, we must understand
impact a bank’s WACC. Acquiring or holding assets requires an aessets stimation oaf n beoth their nd their risk. Banks rea
Acquiring or their haolding assets requires an Becanks
stim
Acquiring or holding requires stimation orf eturn both return and their risk. how those changes impact a bank’s WACC.
for shareholders by investing in assets—mak
‘‘
for shareholders by investing in aassets—making hloans—that ave rate of rraeturn xceeds for shareholders by irnvesting in alaoans—that ssets—making have rate of tarhat eturn that reisk
xce
ssets equires n erstimation of reate baoth heir eturn nd teheir Acquiring or holding assets requires an eAcquiring stimation oor f hbcolding oth their return aond their isk. Bto anks vtttractiveness alue of ccapital. Tahus, the cost oof f cn
apital is used to
of apital. T
hus, t
he c
ost f c
apital i
s u
sed a
ppraise t
he ew l
oans t
hat of capital. Tfor hus, the cost of cbapital is used to appraise the attractiveness oave f new loans trhat will s
hareholders y i
nvesting i
n a
ssets—making l
oans—that h
a
r
ate o
f eturn t
hg
requires
an
estimation
t heir c ost of
for shareholders by investing in assets—making loans—that that exceeds h
Acquiring
ave a r ate or
holding
o
f r eturn assets
1
of T 1hus, R OE ( net both
income/equity) c ost R(net OE (inet income/equity) is equal its Return n ulti
As
of return
capital uRsed too atssets, ppraise tghe attractiveness f leverage n
ew looan
is equal tio s ts eturn n Banks
A
by to to
he m
their
their
risk.
create
value
for multiplied of capital. Thus, the cost of capital is used tco apital. appraise thich he the aquity ttractiveness oand
f those niew loans hat ill ncome/assets) enerate 1
to w
which quity is used finance those am
ssets (assets
ROE (net income/equity) is to ew
qual teo its R
Assets, (net income/assets) meultiplied by tto he leverage ultiplier,
is eturn used to ofn inance assets (assets/equity). in assets—making loans—
i s u sed t o f inance t hose shareholders
a ssets ( assets/equity). by
investing
to w
hich equity (net income/equity) s em
qual to its eturn on Aexceeds
ssets, (net income/assets) that ihave
a rate
of bRreturn
their
cost
ROE (net income/equity) is equal to its Return on RAOE ssets, (net income/assets) ultiplied y the lthat
everage multiplier, the of
degree multiplied by the levera
is used to finance those assets (assets/equity). The Modigliani-Miller
irrelevance
to w
hich e
quity capital. Thus, the cost of capital is used to appraise the
to which equity is used to finance those assets (assets/equity). 1
1
proposition is the starting point for
capital structure; it is not
analyzing
the
ending point.
In addition to expecting a return, equity investors
and creditors incur a cost when they finance a business’s
assets. This cost relates to the risk of the assets they are
financing. They could earn returns on other investments
with similar risk profiles. This opportunity cost comprises
the minimum rate of return the business needs to earn
on its assets to meet the demands of its debt and equity
investors (Higgins 2011). This is the firm’s cost of capital.
A company’s cost of capital is known as its Weighted
Average Cost of Capital, or WACC. It states that a
company’s overall cost of capital is the cost of each
1
38
ROE (net income/equity) is equal to its Return on Assets, (net
income/assets) multiplied by the leverage multiplier, the degree to
which equity is used to finance those assets (assets/equity).
attractiveness of new loans that will generate risky cash
2 flows. The risk-return calculation on whether to make
those loans is determined by “discounting” the cash flows
from the loan by the cost of capital. Thus, if a bank’s cost
of capital exceeds the rate of return derived from cash
flows from a new loan, the loan will not be made or the
bank will increase the rate charged for the loan so that it
exceeds its cost of capital.
Since debt provides a fixed return and contractual
certainty to the debt holder, the cost of debt is an
observable data point and is simply the yield-to-maturity
on the debt and other liabilities issued by the bank.2
High-grade U.S. companies, for example, issue debt at an
average of approximately 5% according to historical data
from public sources.3
2
This issue is much simplified for the purposes of this article. This
concept is much more complex and includes estimations of debt
betas, but this is beyond the scope of this article.
3
For example, according to U.S. Treasury Department HQM
corporate yield curve data, the average yield-to-maturity on 10
year high-grade corporate bonds from 2009-2013 was 4.74%
(monthly spot rate). <http://www.treasury.gov/resource-center/
economic-policy/corp-bond-yield/Pages/Corp-Yield-Bond-CurvePapers.aspx>
their assets with a mix of debt (and deposits, a form of debt) and equity, all of which are claims to the firm’s assets. Banks secure financing in the context of competitive and economic forces, as well as regulatory requirements. Capital structure choices have significant tradeoffs for companies in general and for banks in particular. risky cash flows. The risk-‐return calculation on whether to make those loans is determined by and equity are both sources of financing, or capital, but in the banking industry context “capital” is n on whether to make Debt those ltoans is determined “discounting” he cash flows from bty he loan by the cost of capital. Thus, if a bank’s cost of capital exceeds Estimating
cost
of equity,
residual
Using
formula above,
we can estimate
of assets shorthand refer o the irm’s eequity capital. Equity is athe
(residual) ownership claim tthe
o acost
firm’s n fblows. y the cost risk-‐return of the capital. hus, if the
at bo ctost oanf tcfcunsecured
apital xceeds rate cToalculation f return dank’s from ash flows from a new the loan oerived n whether o make ty hose loans is dloan, etermined by will not be made or the bank will lation oTn he whether tclaim,
o that make t
hose l
oans i
s d
etermined b
is more
challenging.
The
key
is
to
examine
the
equity
for
an
average
risk
company.
The
return
on
U.S.
aw
djusts in depending on w
the alue of cash flows that a company is able to generate from its from the a new loan, the loan not by ve talue made othe r bank ill vit increase the rofill ate charged loan so Tthat its cost capital. has exceeded the risk-free
lows the lhus, oan bigenerally
he cfor ost oost f the cto
apital. hus, if eaxceeds bank’s cost ostocks
f ocf apital exceeds types
risks
related
holding
a
risky
common
on average
e ing” loan by ctash he cfost othree
f fcrom apital. T
f a
b
ank’s c
o
f c
apital e
xceeds assets. L
everage, o
r d
ebt c
apital, i
nvolves t
he s
ubstitution o
f f
ixed c
ost debt for the residual claim of hat it exceeds its fcrom ost ocf capital. from a new loan, 4
f return derived foan lows the loan ww
ill ill not be rate
made or the bank will by 6-7% (Higgins 2011). Let’s
asset:tash (1)
the
time
value
ofbmoney,
(2)or an
inflation
on government
bonds
ot lows from a new l
oan, he l
w
ill n
e m
ade t
he b
ank owner’s e
quity.
Leverage i
ncreases e
xpected r
eturn a
nd i
t i
ncreases r
isk. Since debt p5rovides a fixed return and contractual certainty to the debt holder, Lteverage he cost oaf llows debt ais fairm n to create he for the loan sco that it exceeds risk
its premium
cost of crelated
apital. to premium,
and
(3)
a firm-specific
assume a market risk premium of 7%, a 3% rate on a
n tractual so rtate hat cciharged t ertainty exceeds i
ts c
ost o
f apital. to tmultiple he debt hrisk-‐return older, ost of debt arom n any particular ombinations assets Higgins 2011). issued by the observable data point athe nd cis simply the is yfield-‐to-‐maturity on stet he odf ebt and (o
ther liabilities the2 riskiness of the firm’s assets (Higgins 2011). The first
long-term Treasury bond, and a beta of one. The cost of
eld-‐to-‐maturity on rteturn he Hdigh-‐grade ebt and other liabilities issued bxample, y tdhe bank.
U.S. for tehe dcapital
ebt n oaf +verage pproximately 5assumptions,
% according t cpontractual rovides a fixed cdontractual certainty ebt hissue older, the act ost d1ebt is oaf =n a10%.
two Banks are
thecompanies, rate
a c“risk-free”
government
isaassets 3%
* (7%)
Under these
d certainty to aequivalent
tnd he ebt tovhalue older, ton
he ost too f 3 rdate ebt is aeturn n c
reate b
y e
arning a
o
f r
o
n t
heir f
or e
quity h
olders, a
nd c
apital structure mple, issue debt t istorical asimply n average f from approximately 5n % the according to aihs dlong-term
ata public sources.
which
debt for
e dyata point and he yoield-‐to-‐maturity obond,
ay nd other an
liabilities issued by the has a cost of equity of 10%.
bond,
U.S.
Treasury
our
average-risk
U.S. company
he ield-‐to-‐maturity ochoices n tlike
he tad
ebt a
nd o
ther l
iabilities i
ssued b
t
he can impact that return. A6t an operating level, the relationship between leverage and return on gh-‐grade U.S. companies, for ebe
iisk-‐return ssue debt at 3%.
an aoverage of to am
% according purposes
can
assumed
to yield
about
1pproximately ash fxample, lows. n ake those leverage loans i5
etermined by r example, issue debt arisky t an a(verage of he f eraquity, pproximately 5% awccording equity ROE) oan n acalculation umber o
f rhether fesidual actors.
H
igher will increase payments, Estimating tche oTepends u nnsecured c laim, is m
ore s cdhallenging. The interest key is to examine which 3 cost d
3 data from public sources.
Estimates
vary,
but
banks
haveexceeds equity betas of
cal “discounting” t
he c
ash f
lows f
rom t
he l
oan b
y t
he c
ost o
f c
apital. T
hus, i
f a
b
ank’s c
ost o
f c
apital 4
.d r esidual claim, is tmhree ore cdypes hallenging. Tghe koey s tro examine will ecrease return n aissets. But t w
ill also ad ecrease taxes and the ff irms leverage (2) am
n ultiplier. the f risks elated tio haolding isky asset: (1) time vbalue m
oney,
8 increase the tcan
rate we
of o
rmeasure
eturn derived from cash frisk
lows premium?
from new loan, trhe loan will not b1.2.
e tmhe ade or the ank woill How
a enerally firm-specific
approximately
Using
the
formula
above,
banks
4
5
(ore 2) o hthe olding ao rf isky asset: (1) he tihe time alue oney,
ntet mpact on (3) RoOE dtirm-‐specific epends n atricn he bp7ank’s rofitability, rofrate, and xisting capital structure. 9 The increase rate cnd harged ff he loan so tohat t exceeds its cpost oelated f capital. o inflation premium,
ravesidual aor m
fis
isk remium tax he iskiness f the firm’s assets.
g cost equity, aThe n laim, hallenging. Trhe key o examine The
risk
premium
beta
(β).
would
haveits attcost
equity
ofeo
approximately
11.5%.
cured residual claim, ifirm-specific
s umnsecured ore challenging. Tche kknown
ey is is mtaso examine 4
risk premium to ratelated he ebeta
rquivalent iskiness of ton
the frirm’s ssets.
first two re o tthe
rate oasset: n a “(Pricing
risk-‐free” government bond, l and
ike f long-‐term U.S. assume
Treasury 1) 4The (c2) types risks rgaelated enerally htolding ahe isky and the time vto alue f mhdeposits
oney,
Estimating
iso based
Capital
Asset
Including
other
forms
debt a fixed r eturn am
contractual caertainty the doebt older, the ost a
on debt is an of debt,
(2) n ted to o
hf olding risky aSince sset: (1) pttrovides he value o rf eturn, oney,
addition t o eime xpecting a.S. equity investors and creditors incur a cost when 10they finance a 6
5overnment In sk-‐free” g
b
ond, l
ike a
l
ong-‐term U
T
reasury wobservable hich for doata ur urposes an bthe e ayssumed abanks
aliabilities ppoint and is sc
imply ield-‐to-‐maturity on the a3nd other issued brate
y the (CAPM),
which
the
can
borrow
at an average
2%. Let’s now
o yield premium,
and bond, (3) aModel
firm-‐specific rrisk pdescribes
remium related the rtiskiness obout f debt the f%.
irm’s ssets.
The ecific risk p remium r elated iskiness of cost the frelationship
irm’s tao tssets.
The 6
2to the business’s a
ssets. T
his r
elates o t
he r
isk o
f t
he a
ssets t
hey a
re f
inancing. T
hey ould earn returns on bank.
H
igh-‐grade U
.S. c
ompanies, f
or e
xample, i
ssue d
ebt a
t a
n a
verage o
f a
pproximately 5
% a
ccording med t
o y
ield a
bout 3
%.
between
returngon
any risky asset
and lits
put all ofUthe
together to answer
thecfollowing
are quivalent gtovernment o the rate othe
n ond, aexpected
“risk-‐free” overnment breasury ond, ike a long-‐term .S. pieces
Treasury 3
n a “erisk-‐free” b
l
ike a
l
ong-‐term U
.S. T
to w
historical data from pw
ublic other im
nvestments ith ssources.
imilar isk profit
rofiles. cost cpomprises minimum rate of 7 return How can e measures
easure firm-‐specific r risk The oquestion:
fpportunity irm-‐specific risk remium its he known as b
(β).
6ppremium? risk.
Beta
theato sensitivity
of a firm’s
to This How will
requiring
banks
to
rely
more
oneta 6assumed ich f
or o
ur p
urposes c
an b
e y
ield a
bout 3
%.
7
assumed tTo yield about 3b
%.
pis remium The cost oo
f cf apital is ebt % +a
1nd * (7%) = 10%. iU
nder these aT
ssumptions, an average-‐risk U.S. company o remium? he firm-‐specific reta isk itn s o kBy
nown bthe
eta (β).Ptricing the eeds arn oan s its meet tore he one. ikts equity nvestors. his is the Estimating business bcnased tehe Aasset (emands CAPM), ds t33escribes the rtheir
elationship overall
economic
overall
expensive
equity
rather
costthese of assumptions, Estimating the conditions.
ost of eoquity, adefinition
n Cuapital nsecured rssets esidual claim, iM
s model cdhallenging. ey d
ithan
o xamine one. The cost oTw
f he chich apital is % e+debt
1 * (impact
7%) = 10%. U
nder an average-‐risk U.S. company has a cost of equity of 10%. 4
has awhich
ctost of vin
eeasures quity of f influences
0%. set Pmricing Model (CAPM), wrchich df the he rirm-‐specific elationship 2) the
an rate banks
the three types ocf one.
risks raelated to hone
olding a a
rpisky sset: (1) tB
he ime alue oeta m1oney,
firm’s oremium? apital. market
aeost beta
ofescribes Agenerally beta
means
capital,
turn
between thas
he xpected return ogreater
n ny than
risky asset nd risk. eta m
tβ).
he 7s (ensitivity of a charge
firm’s on 8
7 aits we easure a
f
irm-‐specific isk p
T
f
r
isk remium i
s k
nown a
s b
(
isk premium? The firm-‐specific risk p5remium is known raisk s bpremium eta (β).related betas of approximately 1.2. Using the formula above, banks vary, banks have equity inflation premium,
saensitivity nd (3) than
a firm-‐specific o Estimates the riskiness obf ut the firm’s assets.
asset aind its risk. Btthat
eta easures tmore
he of market
aCAPM), firm’s aCm
company
isconomic risky
the
awwhole,
and
credit
profit to overall esset conditions. By dasefinition tescribes he loans
otverall m
hoas a bhave eta of The obne. eta greater Estimates velationship ary, availability?
but banks equity etas A
of b
approximately 1.2.8 Using the formula above, banks g b
eta s b
ased o
n he apital A
P
ricing M
odel (
hich d
the rarket would h
ave a
c
ost f e
quity o
f a
pproximately 11.5%.99 Including deposits and other forms of debt, al Asset Pricing Model A first (CAPM), w
hich d
escribes t
he r
elationship two are equivalent to ctapital he rate ios n kanown “risk-‐free” gts overnment bond, like a long-‐term Uf .S. Tapital, reasury or WACC. c
ompany’s c
ost o
f a
s i
W
eighted A
verage C
ost o
C
I
t s
tates hat a and other forms of debt, would have a cost of equity of approximately 11.5%.
Including dteposits and
vice
versa.
efinition the orverall arket hhich as tfahat eta o
f one. A
beta greater 6arket borrow at avn ice average rate 2 %.10
Let’s now put all of the pieces together to answer the
than om
m
eans a pcaurposes ompany i s ore risky than mensitivity abs anks ao f wacan hole, and versa. the expected eturn one n aeta ny isky a bsset nd iensitivity ts cran isk. Bassumed eta m
easures the 3s%.
firm’s 10
bond, wrm
or our be m
to yield about assume risky asset and its risk. B
easures t
he s
o
f a
f
irm’s assume b
anks c
an b
orrow a
t a
n a
verage r
ate 2
%.
L
et’s n
ow p
ut all of the pieces together to answer the
verall cost of c apital is the cost of each Tofollowing particular type of wcill apital—both ebt nd on eequity—
uestion: How requiring banks o rely maore xpensive equity rather than debt impact answerqthat
question,
we
need to
firsttd
understand
sky than the market acompany’s s a whole, aoefinition nd vice vtersa. overall e
conomic c
onditions. B
y d
he o
verall m
arket h
as a
b
eta o
f o
ne. A
b
eta g
following question: Hreater ow will requiring banks to rely more on expensive equity rather than debt impact 7
By definition tTherefore, he overall arket heasure quity bap eta f o) ne. A tpbhe eta greater opredicts
f capital, hich in influences ate banks charge on loans and credit availability? How m
an w
froportion irm-‐specific riisk remium? The free firm-‐specific risk premium nown ats urn bexamine
eta β). real-world
weighted bmy tas n crisk
ompany’s cinterest apital scctructure: kw
Therefore,
the
cost
(o𝐾𝐾
the
free
whattheir theory
and
then
tche ce ost oheir f ofaeequity
equals the risk rost ate n gis overnment b(onds (tthe 𝑅𝑅!rr) plus the ! ) equals
their ost of o
capital, w
hich in turn influences he ate banks charge on loans and credit availability? means t
hat a
c
ompany i
s m
ore r
isky t
han t
he m
arket a
s a
w
hole, a
nd v
ice v
ersa. Estimating b
eta i
s b
ased o
n t
he C
apital A
sset P
ricing M
odel (
CAPM), w
hich d
escribes t
he r
elationship ore isky than the m
arket a
s a
w
hole, a
nd v
ice v
ersa. he rrisk free interest r
ate o
n g
overnment b
onds (
𝑅𝑅
) p
lus t
he interest raterisk on government
bonds
plus the
firmfactors
may
deviate
from
the
framework.
To athat
nswer that T
qhe uestion, we need ttheoretical
o first understand what theory predicts and then examine real-‐world
! t) imes firm-‐specific p
remium: b
eta (
β) t
he M
arket R
isk P
remium. M
arket R
isk P
remium i
s d
efined To answer t!the hat question, w
e an eed to first understand what theory predicts and then examine real-‐world
between the expected return on any risky asset and its risk. Beta easures sensitivity of irm’s ! mfactors m) ay deviate from tfhe theoretical ramework. that higher equity and less mprofit verall beta
above 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊
= 𝐾𝐾
( Theory
) factors +b onds 𝐾𝐾hpredicts
(tthat specific
risk
premium:
(β)
times
theBMarket
Risk
that
higher
equity
and less ffleverage
inTTheory a ppredicts the Mcarket Reisk Premium. T
he M
arket R
isk P
remium i
s d
efined !rate !as hat m
ay d
eviate f
rom t
he t
heoretical ramework. heory redicts that higher equity and less , t
he ost o
f quity (
𝐾𝐾
) e
quals t
he r
isk f
ree i
nterest r
ate o
n g
overnment (
𝑅𝑅
) p
lus t
he as t
he arket r
eturns o
ver a
nd t
he r
isk f
ree 𝑅𝑅
−
𝑅𝑅
.
t
o o
e
conomic c
onditions. y d
efinition t
he o
verall m
arket a
b
eta o
f o
ne. A
b
eta g
reater !!!
!!!
! rate on government bonds (𝑅𝑅 ) plus the !
!"#
! leverage i
n a
b
ank’s c
apital s
tructure w
ill l
ower t
he b
ank’s b
eta, w
hich w
ill reduce the cost of equity uals the risk free interest !
Premium.
Risk
Premium
isore defined
the
capital
will
the
bank’s
which
leverage astructure
bvank’s capital slower
tructure will lower tbeta,
he bank’s beta, which will reduce the cost of equity ne eans that a company is P
m
risky tas
han the market arket bank’s
as aisk w!hole, ain nd ice vs ersa. risk rfisk ree rremium: ate 𝑅𝑅!"#
− than 𝑅𝑅
.imes The
mMarket
(𝐾𝐾
). Lremium everage increases b oth risk and return. Bank betas capture the risk of the bank’s assets plus the ! o
ific p
b
eta (
β) t
t
he M
arket R
isk remium. T
he M
R
P
i
d
efined (𝐾𝐾
mes the Market Risk PThis remium. Tover
he Market Rthe
isk remium is cdost efined Leverage io
ncreases both risk a).
nd imes return. tBhe ank pbroportion etas capture the bank’s assets plus the market
returns
and
above
free
rate
will incremental reduce
cost
of
equity
formula tells us that Pcompany’s of capital i!s ). its cthe
ost equity (( 𝐾𝐾
of risk of tahe risk rf elated to leverage. etas can bincreases
e “unlevered and relevered” ccording to target capital ! ) tBLeverage
𝐾𝐾a) risk
𝑅𝑅!the + r 𝛽𝛽
∗free (𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃) ! e=
incremental t
o l
everage. B
etas c
an b
e “
unlevered a
nd r
elevered” a
ccording to target capital Therefore, the cost foree f equity (𝐾𝐾! 𝑅𝑅
quals isk i
nterest r
ate o
n g
overnment b
onds (
𝑅𝑅
) p
lus t
he 11 risk related rket r
eturns o
ver a
nd a
bove t
he r
isk r
ate −
𝑅𝑅
.
!
!"# !
! structure.
Thus, the cost of equity will decline as a bank relies more on equity capital. Returning to e 𝛽𝛽the risk free rate ( 𝑅𝑅!"#
− 𝑅𝑅in . capital structure risk (and
11 return. Bank betas capture the risk of the
! ).
∗ (𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃) ) pMlus the cost oboth
f dWACC, ebt 𝐾𝐾
t
imes he o
f i
n t
he apital equity its ( the structure.
)T hus, the ctost of peroportion quity will decline ad
s ebt a bank relies mcore on equity capital. Returning to !
firm-‐specific risk premium: beta (β) times arket R
isk P
remium. T
he M
arket R
isk P
remium i
s d
efined even though higher bank equity capital requirements will force banks rely more on expensive !!!
assets
plus
the hincremental
riskcrelated
to rleverage.
WACC, even ta
hough igher bank equity apital Trhe equirements Using the fhe ormula bove, we and can estimate he rcate ost 𝑅𝑅o!"#
f ebank’s
quity an verage risk company. eturn woill n force banks rely more on expensive !
as t=
market raeturns over above the risk ftree −
𝑅𝑅! . f or equity (11.5%) than cheaper debt (2%), the cost of the equity will decline to precisely offset new capital 𝐾𝐾
𝑅𝑅
+
𝛽𝛽
∗
(𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃) !
!
structure(
). T
o u
nderstand h
ow a
d
ecrease i
n l
everage o
r a
n i
ncrease i
n e
quity c
apital equirements 𝑅𝑅 t!he +c 𝛽𝛽
∗
(𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃) equity (
11.5%) t
han c
heaper d
ebt (
2%), t
he c
ost o
f t
he erquity will 12
decline to precisely offset new capital Betas
“unlevered
and
relevered”
to
ost of equity an average risk he erxceeded eturn on the risk-‐free structure eightings (see footnote for formulas and c(alculations).
Of course, all things being equal, a !!!
U.S. fcor ommon stocks on caompany. verage hTas rcan
ate beown government bonds baccording
y 6-‐7% Higgins 12
structure w
eightings (
see f
ootnote f
or f
ormulas a
nd c
alculations).
Of course, all things being equal, a 11
𝐾𝐾
=
𝑅𝑅
+
𝛽𝛽
∗
(𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑅𝑅𝑅𝑅𝑅𝑅𝑅𝑅 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃) !
!
less l
evered b
ank w
ill b
e a
ble t
o b
orrow m
ore c
heaply t
oo. target
capital
structure.
Thus,
the
cost
of
equity
will
will a
ffect l
oans r
ates, c
redit e
xtension, a
nd f
inancial s
tability, w
e m
ust u
nderstand h
ow t
hose c
hanges ded the raisk-‐free rate o
n egstimate overnment bost onds brisk y 6-‐7% (Higgins 2011). Let’s assume a m
arket premium overage f 7%, ar 3isk % crate n a long-‐term reasury bond, a beta o f mate formula bove, w
e c
an t
he c
o
f e
quity f
or a
n a
ompany. T
o
n less olevered bhe ank rweturn ill be aTble to borrow more cheaply too. the cost of equity for an average risk company. The return on decline as a bank relies more on equity capital. Returning
a fbormula ank’s W
an idea that the cost of eT
quity declines Using the atbove, wbe ond, cto
n The average company. he return on to precisely offset additional reliance on more expensive equity
m of 7s%, a 3% ate o4n impact aThe
hlong-‐term Treasury ar ate beta ocost
f gcost timee
value
of money
is ACC. related
theestimate opportunity
of of equity for mon tocks on rrisk-‐free average as xceeded he risk-‐free othe n overnment baonds by that 6risk -‐7% Higgins The idea he c(ost of equity declines to precisely offset additional reliance on more expensive equity
xceeded the rU.S. ate oA n government bonds bey 6now
-‐7% Higgins onceptually ound tbhigher
hough subject tequity
o numerous simplifying assumptions—assumptions that vary in tooWACC,
even tthough
bank
capital
money.
dollar
today
andon a dollar
a year
from
are t(not
equal.
common stocks average has xceeded he risk-‐free rate n is gcovernment bsonds y 6-‐7% (Higgins r isk A dollar
p remium a year
from
o now
is worth
a 3 less
r than
aodollar
is conceptually ound to
hough subject to numerous simplifying assumptions—assumptions that vary in t’s assume a m
f 7 a%, % ate n aa otoday,
lbong-‐term Treasury bdoth ond, aw bshich eta f reflect because
the egree t
o t
hey r
eality. I
ndeed, t
he foregoing analysis took into account only the mium of 7%, a arket 32 T% r
ate o
n a
ong-‐term T
2011). Llet’s assume mreasury arket risk bprond, remium f eta 7
%, ao stimation 3f % rate on a
l
ong-‐term T
reasury b
ond, b
eta o
f Acquiring o
r h
olding a
ssets equires a
n e
o
f b
t
heir r
eturn a
nd t
heir r
isk. B
anks create value requirements
force
banks
to
rely
more
on
expensive
his issue much or money.
the purposes this required
article. This concept much ore omplex arnd includes estimations oaf nalysis the dis egree twill
o m
which tchey reflect eality. Indeed, the foregoing took into account only the oneis could
earnsimplified interest on fthe
Thus, part ooff the
narrow set of factors. debt b
etas, b
ut t
his i
s b
eyond t
he s
cope o
f t
his a
rticle. narrow s
et o
f f
actors. return
on
a
risky
asset
is
to
compensate
the
investor
for
the
for s
hareholders b
y i
nvesting i
n a
ssets—making l
oans—that h
ave a
r
ate o
f r
eturn t
hat e
xceeds t
heir c
ost is article. This concept is much more complex and includes estimations of athat
ccording could
be
t o U
.S. T
reasury their
money.
Department HQM corporate yield curve data, the average yield-‐to-‐maturity on 10 3 F or e xample, interest
earned
on
Discussions of capital structure and corporate finance often begin with the theoretical framework of 2
le. issue is mT
uch simplified the po
urposes of this ias rticle. This tconcept is much mtore complex nd includes estimations of loans that will generate of Tchis apital. hus, the Tfcor ost f capital umsed o (monthly appraise he attractiveness of new Discussions caapital structure s much simplified year for the purposes corporate of this article. his concept is much complex and includes of and corporate finance often begin with the theoretical framework of high-‐grade bonds from 2009-‐2013 was 4ore .74% spot rate). eo<f stimations http://www.treasury.gov/resource-‐
& Miller (MM), which that, under certain conditions and when cash flows are held 8 Modigliani See: PWC (2013),
King
(2009)
andshows Handorf
(2011)
debt etas, ut his is cbomplex eyond the snd cope of this article. nt orporate yield dbmata, average yield-‐to-‐maturity ostimations n 10 s oH
f tQM his acrticle. This concept is required
uch bthe mtore aasset
includes einclude
of 5 curve The
return
on
any
risky
must
also
Modigliani & Miller (MM), which shows that, under certain conditions and when cash flows are held 3
but his is eyond center/economic-‐policy/corp-‐bond-‐yield/Pages/Corp-‐Yield-‐Bond-‐Curve-‐Papers.aspx> the scope his corporate yield curve constant, data, the atverage y ield-‐to-‐maturity on 10 carries has no effect on its value. Capital structure is irrelevant
he amount of debt a company compensation
F oor f < e thttp://www.treasury.gov/resource-‐
xample, a rticle. a to ccording the
investor
t o U .S. for
T reasury loss
D ofepartment purchasing
HQM as 4t.74% monthly s
pot r
ate). s article. (b
the
power
over
4
the amount of 1(including
ebt a company carries has no effect on its value. Capital structure is irrelevant
9ate). 3%
1.2*(7%)
= a11.5%
some
rounding).
1 year high-‐grade corporate belated onds rom 2t009-‐2013 was 4.74% spot < http://www.treasury.gov/resource-‐
le, according U.S. Treasury D
QM corporate yield curve data, he verage yconstant, ield-‐to-‐maturity oiultiplied n The MM framework llustrates aban pn
oint: ost ncot ompanies reate value by managing their The time vlife
alue o f d
m
oney is arverage he c(monthly ost of am
oney. d+ollar today nd a dd0 ollar ear rom ow aultiplier, re the
ROE (net income/equity) ifs qual too pportunity its Return o
n A
ssets, (rnet iAncome/assets) m
y yitmportant he lfeverage mm
the dcegree p-‐Yield-‐Bond-‐Curve-‐Papers.aspx> of the
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artment HQM to corporate yield cepartment urve ata, tH
he yeto ield-‐to-‐maturity on 1t0 center/economic-‐policy/corp-‐bond-‐yield/Pages/Corp-‐Yield-‐Bond-‐Curve-‐Papers.aspx> M
M framework illustrates an important point: most companies create value by managing their The ade c
orporate b
onds f
rom 009-‐2013 w
as 4
.74% (
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pot r
ate). <
http://www.treasury.gov/resource-‐
42ollar equal. A
d
a
y
ear f
rom n
ow i
s w
orth l
ess t
han a
d
ollar t
oday, b
ecause o
ne c
ould e
arn i
nterest o
n t
he m
oney. T
hus, p
art o
f to w
hich e
quity i
s u
sed t
o f
inance t
hose a
ssets (
assets/equity). 10
Elliot
(2013)
uses
a
2%
cost
of
debt
for
banks.
The
careful
reader
nity c
ost o
f m
oney. A
d
ollar t
oday a
nd a
d
ollar a
y
ear f
rom n
ow a
re n
ot T
he t
ime v
alue o
f m
oney i
s r
elated t
o t
he o
pportunity c
ost o
f m
oney. A
d
ollar t
oday a
nd a
d
ollar a
y
ear f
rom n
ow a
re n
ot 013 was 4.74% (monthly spot rate). <http://www.treasury.gov/resource-‐
There rare
many
considerations
a risk-free
rate.
Thebecause ofne nomic-‐policy/corp-‐bond-‐yield/Pages/Corp-‐Yield-‐Bond-‐Curve-‐Papers.aspx> the ro6
equired a rfisky is to lcess ompensate he or ctould he hat ould bbanks’
e Tehus, arned oof n their money. to be
Ae darn ollar io
an y ear rom naow ito
s m
westimating
orth a dpollar arn interest on fact
tche m
oney. part of
mayienterest note
the todd
that
cost
debt
is assumed
dollar today, because ne cequal. ould eturn nterest on tsset he oney. Tthan hus, art ttooday, f investor es/Corp-‐Yield-‐Bond-‐Curve-‐Papers.aspx> 5
standard
methodology
among
finance
toinvestor select
the required return oan cny aost risky asset is to practitioners
compensate tis
he for the interest t hat c t rom ould b nvestor e e arned of or n tot heir m
oney. f purchasing 8ear less
that
the
assumption
on
the
risk-free
rate.
This
is related
alue o
f m
oney i
s r
elated t
o t
he o
pportunity o
f m
oney. A
d
ollar t
oday a
nd a
d
ollar a
y
f
n
ow a
re n
T
he r
equired r
eturn o
n r
isky a
sset m
ust a
lso i
nclude c
ompensation t
o he i
t
he l
oss o
power toover 2 See: PWC (2013), King (2009) and Handorf (2011) e the investor the interest that could e oean arned oTreasury
heir maoney. are portunity cost foor f m
oney. Aeither
5d Tollar today abnd adny ollar an ytear fyield.
rom ninclude ow not 8
10-year
or
30-year
U.S.
One
can
also
use
9
he raequired return risky a sset must lso compensation to the investor f.2*(7%) or t(2013), he banks
l=oss of engage
p((urchasing pandorf ower o(transformation
ver S3he ee: King 2009) ain
nd 2011) the
that
maturity
(maturity of
% fact
+m
P1WC T1hus, 1.5% including sHome rounding). lar a
y
ear f
rom n
ow i
s w
orth l
ess t
han a
d
ollar t
oday, b
ecause o
ne c
ould e
arn i
nterest o
n t
oney. p
art o
f the l
ife o
f t
he i
nvestment.
9
clude t
o t
he i
nvestor f
or t
he l
oss o
f p
urchasing p
ower o
ver 10
han a dcompensation ollar today, b
ecause o
ne c
ould e
arn i
nterest o
n t
he m
oney. T
hus, p
art o
f the l
ife o
f t
he i
nvestment.
historical
averages.
In
general,
the
maturity
of
the
risk-free
rate
3
% +
1
.2*(7%) =
1
1.5% (
including s
ome r
ounding). E
lliot (
2013) u
ses a
2
% c
ost o
f d
ebt f
or b
anks. T
he c
areful r
eader m
ay n
ote t
he o
dd f
act t
hat banks’ cost of debt is assumed to
risk-freetheir rate matches
asset
life while
borrowings
are short-term
in
6 compensate the investor for the interest that could be earned 10 on m
d return tohe n ainvestor risky 6a Tsset o mssumption atshould
re many o m
risk-‐free ate. The smtandard mong inance phis ractitioners iay s fact tno iTnterest here are cm
any onsiderations to eestimating stimating a ra
isk-‐free rate. standard ethodology aethodology mong foney. inance p aoractitioners tro Ellliot 2013) a 2% cost of the debt ffor bis anks. careful reader ote the odd feact that in banks’ cost transformation of debt is assumed to
be ess t(hat the uases n risk-‐free ate. TThe is related to tm
he that banks ngage maturity match
thecclife
of the
with
the
30-year
Treasury
pensate fhere or tis he tonsiderations hat ould be investment,
etarned on their oney. Trhe nature).
select 1include r c3ompensation 0-‐year U.S. O
ne O
also use hlso istorical n gisk-‐free the mmatches aturity of the isk-‐
be that trhe assumption oIo
n ver tg
he ate. his is related to he fact that engage in maturity transformation ed return ny rselect isky asset mtust a0-‐year lso to ytield. he nvestor or tahe loss f verages. pless urchasing power (maturity oIf rate arisk-‐free sset life rtw
hile Tm
b
orrowings aore in bnanks ature). emither ae 1ither or for 3o0-‐year U
TTpreasury reasury yield. ne cfver an use oah
istorical aeneral, verages. n eneral, he aturity f stthort-‐term he risk-‐
yield
used
toaassess
perpetuity
value.
-‐free rate. oTn he standard ethodology a0-‐year mong fhe inance p.S. ractitioners iis tower o can also include caompensation tfree o he i
nvestor t
l
oss o
f urchasing p
o
11
f nlever risk-‐free rate matches lbife wb
hile borrowings short-‐term in nature). rate should match the life of the investment, with the 30-‐year Treasury yield (maturity u sed o aoussess erpetuity value. sset We ctan and relever the eaquity eta y the following afre he 11
rate 7should match life otf he the investment, with the 30-‐year T11
reasury yield upsed o assess p erpetuity alue. f ormulas: We
can
unlever
relever
theequity equity
beta
following
d. Oinvestment.
ne can also use free historical ahe verages. In at gfhe eneral, m
aturity f the risk-‐
!"# !! o
,!!"#
We can unlever aand
nd rtelever the beta by tby
he vfthe
ollowing ormulas: T
f
ormula f
or irm’s (
i) b
eta i
s: 𝛽𝛽
=
T
his e
quation s
ays t
hat a
f
irm’s b
eta i
s v
olatility o
f t
he f
irm’s e
quity, 7
The
formula
for
a
firm’s
(i)
beta
is:
This
equation
!
!"#
!
,!
7 to estimating a risk-‐free rate. The standard !"#$
!"# (!!"#
many ethodology among sfays inance paractitioners is −tvo !"#
formulas:
𝛽𝛽
𝛽𝛽!"#"$"%b
/(1
+ i1s 𝑡𝑡𝑡𝑡𝑡𝑡
)o
f the firm’s equity, ith he considerations 30-‐year Treasury yield uthat
sed o fairm’s ssess erpetuity vof
alue. t o ! mt) he The formula fethodology or (i) bathe
eta is: 𝛽𝛽a!nd =
This t!"#$%$&$' hat =firm’s eta olatility g a rtisk-‐free rate. The standard m
apismong finance p!"# (!
ractitioners teo quation !"#$%&
!"#$
says
attafirm’s
beta
volatility
the
firm’s
equity,
correlated o the m
arket s a w
hole scaled verall is volatility of the market. ) 𝛽𝛽t!"#$%$&$' = 𝛽𝛽!"#"$"% /(1
+he 1 −risk-‐
𝑡𝑡𝑡𝑡𝑡𝑡
) !"#o
r y ay 1ield. 0-‐year o
r 3
0-‐year U
.S. T
reasury y
ield. O
ne c
an a
lso u
se h
istorical a
verages. I
n g
eneral, he m
aturity o
f t
!"#$%&
One can says also tu
se ah istorical ato
verages. general, he maturity ooverall
f tohe risk-‐volatility of the market. correlated
the
ao
whole
and
too the
This equation hat firm’s beta is vmarket
olatility f the ftirm’s equity, !"#$
to the m
arket as In aas
hole aTnd sscaled
caled the verall 𝛽𝛽!"#"$"% =v𝛽𝛽alue. ) ould w
mith atch the life correlated of Ttreasury he investment, wmarket.
ith 3 w0-‐year reasury ytield ∗ (1 + 1 − 𝑡𝑡𝑡𝑡𝑡𝑡 !"#$%&
!"#$%$&$'
3 !"#$
volatility
of the
ent, the 30-‐year yield used to tahe ssess perpetuity value. used to assess perpetuity 𝛽𝛽!"#"$"% = 𝛽𝛽!"#$%$&$' ∗ (1 + 1 − 𝑡𝑡𝑡𝑡𝑡𝑡 !"#$%& ) !"#
!
,!
he o
verall v
olatility o
f t
he m
arket. ! !"#
!la ,!
12
T
his e
quation s
ays t
hat a
f
irm’s b
eta i
s v
olatility o
f t
he f
irm’s e
quity, ! for !"#a firm’s (i) beta is: 𝛽𝛽! =
A
ssume a
b
ank e
quity b
eta o
f 1
.2 a
nd c
ost o
f e
quity of 11.5%, a tax rate of 35%, This equation says that a firm’s beta is volatility of the firm’s equity, 3 and a starting capital structure of 94% (!
) !"# (!!"# ) 12
!"#
o market as vaolatility w
scaled to the hole aond d tthe o the overall f the market. overall volatility of the market. 3 3 Assume Tahe bank equity beta of 1.2 and c+ost of equity W
of e 1c1.5%, a tax of 35%, and oaf s0tarting capital tructure of 94% leverage. WACC is 2.6% [(.0115*.06) (.02*.94)]. alculate an ruate nlevered beta .11 using the asbove formula (1.2 / (1 leverage. The WACC s 2.6% [(.0115*.06) (.02*.94)]. We calculate an unlevered beta f 0.11 using tw
he ormula (1.2 / (1 + (.65) * (.06/.94)) = .i11. Relevering at a n+ew, more equity-‐reliant capital structure of 8o5% leverage, e agbove et a bfeta of .50, and a + (.65) * (.06/.94)) Relevering t aACC new, m.7% ore [e(.065*.15) quity-‐reliant capital structure 85% leverage, we tghe et incremental a beta of .50, and new cost of equity =o f .11. 6.5%. The new aW
is 2
+ (.02*.85)]. The .1% odf ifference reflects loss of a Banking
Perspective
Quarter
4
2014
new shields. cost of equity of 6.5%. The new WACC is 2.7% [(.065*.15) + (.02*.85)]. The .1% difference reflects the incremental loss of tax tax shields. 3 39
4
4
Too Much of a Good Thing: The Implications of Higher Capital Requirements
equity (11.5%) than cheaper debt (2%), the cost of the
equity will decline to precisely offset new capital structure
weightings (see footnote for formulas and calculations).12
Of course, all things being equal, a less levered bank will
be able to borrow more cheaply, too.
growth, or financial stability (Admati and Hellwig 2013).
The argument rests on a gross oversimplification of the
complexities involved in bank capital structure.
Empirical support for beta’s responsiveness to changes
in leverage
is pfar
less established
in reality
thantit
in real assets will hav
assets to maximize cash flows. Rearranging the roportion of paper claims o isthese The idea that the
cost
of equity
precisely
theory
& Amit 1999, Baker & Wugler 2013).
no effect on cdeclines
ost of ctoapital, asset value, or (Abuaf
firm value. offset additional reliance on more expensive equity
Corporate finance research that assesses the factors
is conceptually sound
subject to numerous
involved
in estimating
of capitalcand
capital
The though
MM irrelevance proposition is the starting point for cost
analyzing apital structure; it is not the ending
simplifying
assumptions—assumptions
that
vary
in
the
structure
decisions
often
exclude
banks
altogether
due and perfectly rationa
point. Its conditions are crlaims igorous, including no taxes, no asymmetric information, assets to maximize cash flows. Rearranging the proportion of paper to these real assets will have degree
whichothey
reflect
reality.
Indeed, the
foregoing world. to the
nature
banks’tuse
leverage
andyet theremains foundational no effect on cost of capital, asset tovalue, r risk-‐based firm value. p ricing—a frictionless Munique
M does not of
reflect he of
real world, analysis took into because account only
the
narrow
set
of
factors.
role
of
regulation
(King
2009).
There
are
surprisingly
it forces us to be precise about those factors that make capital structure decisions important.
The MM irrelevance proposition is the starting point for analyzing capital structure; it istudies
s not the nding few
on ethe
cost of bank equity and there is a clear
reality, there asymmetric re a number of factors related to crational apital structure choice that do matter. But some use point. Its conditions are rigorous, i
ncluding n
o t
axes, n
o a
i
nformation, a
nd p
erfectly Discussions of capital structure and corporate finance
need to examine further the trade-offs at stake with bank
this theoretical, foundation to aoundational rgue that there is “no cost…whatsoever” to higher bank risk-‐based pricing—a frictionless world. M theoretical
does not rframework
eflect conceptual the rof
eal world, yet remains often begin
withMthe
Modigliani
capitalfstructure
(Berlin 2011).
equity capital in terms of loan ipmportant. ricing, credit because it forces us to be and
precise about those factors tthat,
hat requirements munder
ake ccertain
apital structure decisions In availability, economic growth, or financial Miller
(MM),
which
shows
stability (Admati and ellwig 2013).
argument reality, there are a number of factors related tcash
o capital structure cHhoice that do mThe atter. But some urests se on a gross oversimplification of the complexiti
conditions
and
when
flows
are
held
constant,
the
this theoretical, conceptual f
oundation t
o a
rgue t
hat t
here i
s “
no c
ost…whatsoever” t
o h
igher b
ank involved carries
in bank apital tructure. amount of debt a company
has cno
effectson
its
equity capital requirements in terms loan pricing, credit aThe
vailability, economic growth, or financial of Bank Capital
value.
Capitalof structure
is irrelevant.
MM framework
The Relevance
Empirical s
upport f
or b
eta’s r
esponsiveness tco omplexities changes in leverage is far less established in reality than
stability (Admati and Hellwig 2
013).
The a
rgument r
ests o
n a
g
ross o
versimplification o
f t
he illustrates an important point: most companies create
Structure
involved in bank capital structure. is their
in theory & Acash
mit flows.
1999, Baker & Wugler 2013). Corporate finance research that assesses the value by managing
assets to(Abuaf maximize
factors involved in estimating cost of capital and apital structure ecisions Rearranging the proportion
of paper claims
to these real
A number
ofcreal-world
frictions ddeviate
fromoften the exclude banks Empirical support for beta’s responsiveness to changes in leverage is far less established in reality than it to the asset
unique ature irrelevance
of banks’ condition
use of leverage a
nd t
he r
ole o
f regulation (King 2009). assets will have noaltogether effect on costdue of capital,
value,nor
of a Modigliani and Miller world.
is in theory (Abuaf & Amit 1999, Baker & Wugler 2013). Corporate finance research that assesses the firm value.
Inthe general,
debt
can impact
the
value
cashnflows
There re surprisingly ew studies on cost of bank equity and a coflear eed tfor
o examine further the factors involved in estimating cost of capital and a
capital structure dfecisions often exclude banks banks(Berlin and nonbanks in five primary ways: tax
tradeoffs t stake w
ith the bank capital sboth
tructure altogether due to the unique nature of banks’ use of aleverage and role of regulation (King 2009). 2011). The MM irrelevance
proposition
is
the
starting
point
benefits,
market
signaling, flexibility, distress costs, and
There are surprisingly few studies on the c ost of bank equity and a clear need to examine further the for analyzing capital structure; it is not the ending
management incentives (Higgins 2011). In addition, a
tradeoffs at stake with bank capital structure (Berlin 2011). point.
Its
conditions
are
rigorous,
including
no
taxes,
number
The R
elevance o
f B
ank C
apital S
tructure of factors unique to banks impact their cost of
no asymmetric information, and perfectly rational
capital, including socially valuable liquidity production;
of rworld.
eal-‐world frictions from tand
he iregulatory
rrelevance condition f aeffect
Modigliani and Miller worl
The Relevance of Bank Capital Structure A number risk-based
pricing—a
frictionless
MM does
not deviate competitive
dynamics;
and o
the
of
reflect the real world,
yet
remains
foundational
because
programs
In general, debt can impact the value government
of cash flows for blike
oth deposit
banks insurance.
and nonbanks in five primary ways: A number of real-‐world frictions deviate from the irrelevance condition of a Modigliani and Miller world. it forces us to be precise
about those
factorssthat
make flexibility, distress costs, and management incentives (Higgins 2011). In tax benefits, market ignaling, In general, debt can impact the value of cash flows for both banks and nonbanks in five primary ways: capital structure decisions
important.
In reality,
there unique to Taxes
addition, a number of factors banks impact their cost of capital, including socially valuable tax benefits, market signaling, flexibility, distress costs, and management incentives (Higgins 2011). In are a number of factors
related
to
capital
structure
liquidity production; and rsegulatory dynamics; and the effect of government programs like
addition, a number of factors unique to banks impact their cost ocf ompetitive capital, including ocially valuable choice that do matter. But some use this theoretical,
The most common jumping off point from a MM
deposit insurance. liquidity production; competitive and regulatory dynamics; and the effect of government programs like conceptual foundation to argue that there is “no cost…
perspective on capital structure is the effect of taxes. In
deposit insurance. whatsoever” to higher
bank
equity
capital
requirements
the U.S., as in many developed countries, interest costs
Taxes in
terms
of
loan
pricing,
credit
availability,
economic
are a deductible expense for tax purposes. The effect of
Taxes in M
capital
structure is tooreduce
taxesstructure and create is the effect of taxes
The most common jumping off point leverage
from an M perspective n capital The most common jumping off point from In an the MM p
erspective o
n c
apital s
tructure i
s t
he e
ffect o
f t
axes. an
“interest
tax
shield.
”
These
are
incremental
cash flows
s icost
n mofany eveloped 12 Assume a bank equity betaUof.S., 1.2 a
and
equitydof
11.5%, a countries, interest costs are a deductible expense for tax purposes. In the U.S., as in many developed c
ountries, i
nterest c
osts a
re a
d
eductible e
xpense f
or t
ax p
urposes. that firms
generate
from
theirand usecofreate leverage.
interesttax shield.” These tax rate of 35%, and
a starting
capital
structure of 94%
The effect of leverage in cleverage.
apital structure is to reduce taxes an “The
interest ThesWACC
is 2.6%is [(.0115*.06)
(.02*.94)].
calculate
The effect of leverage in capital tructure to reduce +taxes and We
create an an
“interest tax
tax shield
shield.” hese in valuation that it’s integrated
is soTprevalent
ncremental cash (1.2
flows unlevered beta ofare 0.11iusing
the above formula
/ (1 +that (.65) firms generate from their use of leverage. The interest tax shield is so are incremental cash flows that firms generate from their use of leverage. The interest tax into
shield s so portion of the WACC formula:
directly
the idebt
* (.06/.94)) = .11. Relevering at a new, more equity-reliant capital
!
!
prevalent i
n v
aluation t
hat i
t’s d
irectly i
nto t
he d
ebt pThis ortion of tsays
he W
ACC freal
ormula: 𝐾𝐾! (1 − 𝑡𝑡)(
). Th
structure
of
85%
leverage,
we
get
a
beta
of
.50,
and
a
new
cost
of
prevalent in valuation that it’s directly into the debt portion of the WACC formula: 𝐾𝐾! (1 − 𝑡𝑡)(
). . This
formula
that
the
cost
!!!
!!!
equity of 6.5%. The new WACC is 2.7% [(.065*.15) + (.02*.85)].
Thus, a firm introduces more
ays that the eal cTost s introduces an isaan
fter-‐tax cost of idebt
after-tax
cost ((𝐾𝐾! (1 − 𝑡𝑡)). ). Thus,
asaas firm
(1
−rtax
𝑡𝑡)). hus, oaf s daebt firm more formula says that the real cost of .1%
debt is aformula n reflects
after-‐tax cost (𝐾𝐾!loss
The
difference
thesincremental
of
shields.
leverage into biecause ts capital structure, WACC goes down, leverage into its capital structure, its WACC goes down, debt is cheaper its than equity even on a because debt is cheaper than equity even on a
risk-‐adjusted basis. That is, an increased erisk-‐adjusted quity beta from n increase in aleverage will no longer bpeta erfectly baasis. That is, n increased equity from an increase in leverage will no longer perfect
Banking
Perspective
Quarter
4
2014
offset f capital, nd chost ence rate it Ac harges loans, ill go uap nd hence the rate it charges on loans, will go up 40in the cost of capital. A bank’s cost ooffset in tahe of the capital. bank’s ocn ost of cwapital, the more the bank is required to rely on equity. T
his e
ffect o
n b
anks’ c
ost o
f c
apital h
as b
een quantified the more the bank is required to rely on equity. This effect on banks’ cost of capital has been quantifie
It becomes
clear
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consultation with professional advisors.
introduces more leverage into its capital structure, its
WACC goes down, because debt is cheaper than equity
even on a risk-adjusted basis. That is, an increased equity
beta from an increase in leverage will no longer precisely
offset in the cost of capital. A bank’s cost of capital, and
hence the rate it charges on loans, will go up the more the
bank is required to rely on equity. This effect on banks’
cost of capital has been quantified by a number of authors
(Elliot 2009; Stein and Hanson 2010), each of which
predict a moderate increase in lending rates.
‘‘
Calibrating capital requirements
only with respect to bank failure
is problematic in that it does not
account for bank lending functions
and ignores the trade-off between a
lower probability of bank failure and
continuation of lending.
Asymmetric Information, Management Incentives
and Growth
Another important way that capital structure can impact
bank lending is through the incentives that leverage
provides to management in the context of asymmetric
information regarding a bank’s assets and growth
opportunities. A benefit of leverage is that in certain
circumstances it can increase alignment between the
interests of shareholders and management. The addition of
fixed interest expenses to a business’s operating profile can
help discipline management to deploy the firm’s cash flows
to valuable projects (Higgins 2011).
The manner in which debt can align shareholder
and management incentives varies by the investment
opportunities a firm confronts. McConnell and Servaes
(1995) empirically demonstrate that for “low growth”
42
firms in mature industries, “value is positively correlated
with leverage” (page 123). In their analysis, leverage
helps to equilibrate between “overinvestment and
underinvestment” problems. The set of investment
opportunities combined with the interplay of shareholdermanagement incentives will create an optimal amount
of leverage for firms. Given the well-documented
asymmetric information problems unique to banks’ assets
and the mature, highly developed nature of bank industry
conditions, it’s likely that this effect is present and would
impact banks’ lending decisions. McConnell and Servaes
conclude that empirical, real world data show that “debt
policy and equity ownership structure ‘matter.’”
Deposits and Liquidity Production In the banking literature, banks are often described as
“special,” and their specialness derives in part from the
fact that they create liquid deposits that serve as money in
our economy. But deposits are a funding source for banks,
a form of bank debt, and banks are thus unique from most
other companies in that they produce socially valuable
services from the debt liabilities in their capital structure.
Recall that nonbanks create value only from their assets.
Because consumers and businesses demand a liquid,
ready source of funds, there will be a pricing signal, or a
premium, to provide liquid claims in the form of deposits
(De Angelo and Stulz 2013).
In providing deposits, banks create value directly
through their capital structure choices, and debt and
equity are not precisely equivalent risk-adjusted sources
of capital for banks. This is a clear departure from a
theoretical MM world. DeAngelo and Stulz (2013) show
that the provision of “(privately and socially beneficial)
liquid financial claims” makes high leverage optimal
for banks before taking into account taxes, asymmetric
information, deposit insurance, or any other real-world
frictions. They further argue that because MM does not
contemplate the provision of deposit liabilities, MM “is
an inappropriately equity-biased baseline for assessing”
bank capital structure choices (page 3).
Returning to WACC, it follows that singling out banks
for substantially heightened equity capital requirements
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43
will increase banks’ overall cost of capital and thus loan
rates. This is due to a premium associated with bank
deposits as a financing source and, compared with equity
capital, bank deposits are a less expensive source of debt
capital (even on a risk-adjusted basis). Moreover, bank
deposits benefit from FDIC insurance, and while banks
pay premiums for this insurance, the presence of official
support will dampen the risk sensitivity of the providers
of this funding source and reduce the cost of deposit
funding compared to equity.13
‘‘
If asset shrinkage—perhaps by
cutting back on lending—is limited to
a single bank, then other banks can
potentially pick up the slack without major
implications for intermediation activity.
However, there are serious consequences
if multiple banks respond to higher capital
requirements by reducing the flow of
credit to the economy.
Equity Capital, Intermediation, and
Financial Stability
The discussion thus far suggests that equity capital is
more expensive relative to debt for banks. But what are
the implications of requiring banks to have more capital
in their funding mix? Would the heightened capital
requirements have any implications for intermediation
activity? If so, are there further implications for investment
on the part of the borrowers? Would they seek credit
elsewhere and what does it mean for financial stability?
13 Indeed, many argue that this is the reason that high leverage is
optimal for banks.
44
Most discussions of bank capital regulation start from
the premise that the goal is to keep the probability of bank
failure below a certain fixed threshold, typically set in
terms of a “confidence level.” A confidence level of 99.9%,
for example, means that there is only a 0.1% chance that
potential losses will exceed the sum of “expected” and
“unexpected” losses, thus ensuring that probability of
bank failure remains low. Once the confidence level is
set, the necessary level of capital can be calibrated using
information in each bank’s portfolio (Gordy, 2003).
Calibrating capital requirements only with respect to
bank failure is problematic in that it does not account for
bank lending functions and ignores the trade-off between
a lower probability of bank failure and continuation of
lending. In some states of the world, improvements in
financial stability may outweigh the costs of lower output
growth, thus justifying higher capital requirements. In
other circumstances, however, improvements in financial
stability may only be marginal relative to foregone
lending opportunities, thus making capital requirements
“inefficiently” high.
Changes in capital requirements may affect lending in
two ways. First, as we have shown in the previous sections,
raising bank capital requirements results in higher WACC
(Baker and Wurgler, 2013). Thus, if a bank’s cost of capital
exceeds the rate of return derived from cash flows from
a new loan, the loan will not be made or the bank will
increase the rate charged for the loan to cover its cost of
capital. Too-stringent capital requirements may result in
reduction in the supply of credit, underinvestment in the
economy, and thus slower economic growth.
Alternatively, note that capital requirements are stated in
terms of ratios. Faced with increasing capital requirements
relative to total assets or risk-weighted assets, banks may
respond by shrinking their size. To be specific, consider
a bank with assets of $100 that is financed with deposits
and $6 of equity capital, thus having 6% of equity capital
relative to assets. Suppose that a new policy requires the
capital ratio to be at least 10% relative to total assets. The
bank can fulfill the new requirement by either raising
$4 of fresh equity or by leaving its current level of equity
unchanged and shrinking its assets to $60.
A CRITICAL BALANCE
For every well-run company, striking the right balance between risk and
reward is always critical. Today, unprecedented regulatory changes and
obligations make doing so more challenging than ever.
Promontory can help you achieve
and maintain the right balance.
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If asset shrinkage—perhaps by cutting back on
lending—is limited to a single bank, then other
banks can potentially pick up the slack without major
implications for intermediation activity. However, there
are serious consequences if multiple banks respond
to higher capital requirements by reducing the flow of
credit to the economy. Moreover, asset shrinkage on the
part of the regulated banks may push borrowers to seek
credit in a less regulated environment, with potentially
negative consequences for financial stability.
Equity Capital and Intermediation
There is a large literature that explores how shocks to
bank capital impact lending and economic activity. One
of the cleanest studies in this area is by Joe Peek and Eric
Rosengren (1997). Their key insight is that the sharp
decline in Japanese stock prices between 1989 and 1992
was transmitted to the United States via U.S. branches
of Japanese parent banks. Specifically, they find that a
one percentage point decline in the Japanese parent’s
risk-based capital ratio resulted in a 6% decline in loans
originated by the U.S. branches. In a subsequent study,
Peek and Rosengren (2000) analyze the implications of
the decline in lending for real economic activity. They
find that the decline in lending was followed by a sharp
reduction in commercial real estate activity in the U.S.,
especially in states with more U.S. branches of Japanese
parent banks.
Haubrich and Wachtel (1993) analyze the response of
U.S. commercial banks to the 1988-89 announcement
and implementation of higher capital requirements. They
group the banks by their undercapitalization relative
to the new minimum capital requirements and further
segment the banks by their size. Haubrich and Wachtel
find that relatively undercapitalized banks of all sizes
shifted the composition of their portfolio in response
to the new capital requirements, effectively shrinking
their risk-weighted assets. The results are consistent with
Bernanke and Lown (1991), who find a similar pattern
of asset shrinkage in response to capital depletion among
banks in New Jersey during the late 1980s.
46
In a more recent study, Francis and Osborne (2009)
analyze the lending implications of bank-specific, timevarying capital requirements set by regulatory authorities
in the U.K. They carefully construct a time series of bankspecific capital shortfalls and surpluses for the period
1996-2007 and estimate whether banks with capital
shortfalls adjust their lending behavior. Their regression
analyses suggest that a one percentage point increase in
capital ratio results in a 2.4% reduction in risk-weighted
assets, a 1.4% reduction in total assets, and a 1.2%
reduction in lending over a period of four years.
Equity Capital and Financial
Stability
Further, the implications of higher capital requirements for financial stability are not clear-cut. On the one
hand, higher capital requirements reduce probability of
default by forcing shareholders to absorb a larger fraction
of losses in times of distress and by mitigating moral hazard concerns associated with excessive risk taking. On the
other hand, faced with heightened capital requirements,
banks can respond by selling illiquid assets causing asset
prices to decline. Similar assets held by other market participants may decline in value as well, causing additional
asset sell off. This self-reinforcing process increases system-wide financial fragility. Elements of this mechanism
have been described in Shleifer and Vishny (1992).
Furthermore, increasing evidence shows that
regulatory burden and capital requirements steer some
of the traditional banking activities towards the shadow
banking sector. With less supervisory oversight and more
uncertainty about the quality of lending, the growth of
shadow banks poses concerns about allocation of credit,
output growth, and financial stability.
Aiyar, Calomiris, and Wieladek (2014) use a clever
design to assess the impact of changes in capital
requirements on bank lending and the allocation
of credit. Specifically, the authors use differences in
minimum capital requirements for U.K. banks between
1998 and 2007 and find that a 100 basis point increase
in minimum capital requirement for banks regulated by
the Financial Services Authority leads to 6-9% reduction
in lending. Further, their analysis suggests that about
one-third of the reduction in lending is picked up by
branches of foreign-owned banks not regulated by the
FSA. Although foreign-owned banks pick up some of the
lending slack and offset the overall impact on lending,
the “leakage” of lending to less-regulated areas of the
banking system poses concerns for financial stability.
The present debate about the efficient level of bank
equity focuses on the implications of additional capital
requirements for financial stability and economic growth.
At the core of the debate is the cost of equity relative to
debt and how the equity-debt cost differential changes
when banks are required to alter their funding mix.
On the one hand, theory suggests that capital structure
has no impact on the cost of equity relative to debt
(Modigliani and Miller, 1958) suggesting that there is no
reason banks should not face significantly higher minimum
capital requirements (Admati et al, 2013). However,
when abstracting from the stylized and plainly unrealistic
conditions in Modigliani and Miller with, for example, the
introduction of taxes, asymmetric information, and deposit
funding, then the equity-debt mix becomes important in
determining the relative price of equity.
Regulators are probably aware that capital is
more expensive than debt and too-stringent capital
requirements may dampen intermediation activities.
Otherwise, why not set requirements significantly
higher? Indeed, existing empirical literature suggests
that heightened capital requirements are often met with
a reduction in lending, with implications for investment
activity and migration of lending to less regulated
environments. It is important that policymakers evaluate
the substantial regulatory policies imposed on the
banking industry thus far and carefully consider the
macroeconomic implications of further increases in
capital requirements. 
References
2010.
Admati, Anat, Peter M. DeMarzo, Martin F. Hellwig, and
Paul Pfleiderer (2013), “Fallacies, Irrelevant Facts, and
Myths in the Discussion of Capital Regulation: Why
Bank Equity is Not Socially Expensive,” Rock Center for
Corporate Governance Working Paper Series No. 161.
DeAngelo, Harry and Rene M. Stulz, “Why High Leverage is
Optimal for Banks,” May 2013.
Aiyar, Shekhar, Charles W. Calomiris, and Tomasz Wieladek,
“Does Macro-Prudential Regulation Leak? Evidence from
a UK Policy Experiment,” Journal of Money, Credit, and
Banking, 2014, Vol. 46, pp. 181-214.
Francis, William and Matthew Osborne, “Bank Regulation,
Capital and Credit Supply: Measuring the Impact of
Prudential Standards,” FSA Occasional Paper Series No.
36, 2009.
Angelini, Paolo, Laurent Clerc, Vasco Curdia, Leonardo
Gambacorta, Andrea Gerali, Alberto Locarno, Roberto
Motto, Werner Roeger, Skander Van den Heuvel, and
Jan Vlcek, “BASEL III: Long-Term Impact on Economic
Performance and Fluctuations,” Federal Reserve Bank of
New York Staff Report No. 485, 2011.
Handorf, William C., “Capital Management and Bank
Value,” Journal of Banking Regulation, 2011, Vol. 12 (4),
pp. 331-341.
Peek, Joe and Eric Rosengren. “The International
Transmission of Financial Shocks: The Case of Japan,”
American Economic Review, 1997, Vol. 87(4), pp. 495505.
Hanson, Samuel G., Anil K Kashyap, and Jeremy Stein,
“A Macroprudential Approach to Financial Regulation,”
Journal of Economic Perspectives, 2011, Vol. 25(1), pp.
3-28.
Peek, Joe and Eric Rosengren. “Collateral Damage: Effects
of the Japanese Bank Crisis on Real Activity in the United
States,” American Economic Review, 2000, Vol. 90(1), pp.
30-45.
Higgins, Robert, Analysis for Financial Management, 10th
ed. New York, NY: McGraw-Hill, 2012.
Posner, Eric, “How Do Bank Regulators Determine Capital
Adequacy Requirements?” Coase-Sandor Institute for Law
and Economics, Working Paper No. 698, 2014.
Baker, Malcolm and Jeffrey Wurgler, “Do Strict Capital
Requirements Raise the Cost of Capital? Bank Regulation
and the Low Risk Anomaly,” NBER Working Paper No.
19018, May 2013.
Berlin, Mitchell, “Can We Explain Banks’ Capital
Structures?” Federal Reserve Bank of Philadelphia
Business Review, Q2 2011.
Bernanke, Ben S., and Cara S. Lown, “The Credit Crunch,”
Brookings Paper on Economic Activity, Vol. 2, pp. 205-248.
Carlson, Mark, Hui Shan, and Missaka Warusawitharana,
“Capital Ratios and Bank Lending: A Matched Bank
Approach,” Journal of Financial Intermediation, 2013, Vol.
22(4), pp. 663-687.
Elliott, Douglas, “Quantifying the Effects on Lending of
Increased Capital Requirements,” Brookings Institution,
September 2009.
Hirtle, Beverly, Til Schuermann, and Kevin Stiroh,
“Macroprudential Supervision of Financial Institutions:
Lessons from the SCAP,” Federal Reserve Bank of New
York, Staff Report No. 409, 2009.
McConnell, John J. and Henri Servaes, “Equity Ownership
and the Two Faces of Debt,” Journal of Financial
Economics, 1995, Vol. 39, pp. 131-157.
Modigliani, Franco and Merton H. Miller , “The Cost
of Capital, Corporation Finance, and the Theory of
Investment,” American Economic Review, 1958, Vol. 88,
pp. 587-597.
PricewaterhouseCoopers, “Banking Industry Reform: A
New Equilibrium, Part 2: Detailed Report,” June 2013.
Gordy, Michael B. “A Risk-Factor Model Foundation for
Ratings-Based Bank Capital Rules,” Journal of Financial
Intermediation, 2003, Vol. 12, pp. 199-232.
Rosengren, Eric, “Defining Financial Stability, and Some
Policy Implications of Applying the Definition,” Keynote
Remarks at the Stanford Finance Forum Graduate School
of Business, Stanford University, June 2011.
Kashyap, Anil K., Jeremy C. Stein and Samuel Hanson,
“An Analysis of the Impact of “Substantially Heightened”
Capital Requirements on Large Financial Institutions,” May
Shleifer, Andrei and Robert W. Vishny, “Liquidation Values
and Debt Capacity: A Market Equilibrium Approach,”
Journal of Finance, Vol. 47(4), pp. 1343-1366.
47
TCH αnalytics
1. The largest Bank Holding Companies are rapidly building up high quality capital…
BHCs with assets above $100Bill.
Smaller BHCs
14%
12%
10%
8%
2010-Q1
2011-Q1
2012-Q1
2013-Q1
2014-Q1
Chart 1 shows the evolution of the Common
equity Tier 1 (CET1) risk-based ratio for Bank
Holding Companies (BHC) with assets above
$100Bill and for Bank Holding Companies with
assets between $5Bill and $100Bill. On average,
the largest Bank Holding Companies increase their
CET1 risk-based ratio from 8.6% in the beginning
of 2010 to 12.2% by 2014, representing a capital
growth rate of more than 40%. Smaller BHCs, on
the other hand, accumulate capital at a slower
rate, with the CET1 risk-based ratio increasing from
10.5% to 12.1% between 2010-Q1 and 2014-Q1.
The relatively rapid capital accumulation for the
largest Bank Holding Companies reflects, in part,
heightened capital requirements and compliance
with the annual supervisory stress tests.
Source: FR Y-9C.
2. …reducing their systemic risk…
48
(Left Scale)
Smaller companies
(Right Scale)
6%
0.8%
Contribution to Systemic Risk
Chart 2 shows the contribution of the largest Bank
Holding Companies and their smaller counterparts
to systemic risk. The contribution to systemic risk is
based on the SRISK metric described in Viral Acharya,
Robert Engle, and Matthew Richardson’s “Capital
Shortfall: A New Approach to Ranking and Regulating
Systemic Risk,” American Economic Review: Papers
& Proceedings 2012, 102(3), pp. 59-64. SRISK is
a share of each firm’s capital shortfall relative to the
overall capital shortfall in a hypothetical future crisis.
The lines in the chart show the trend in average SRISK
for the largest Bank Holding Companies – those with
assets above $100Bill – and for smaller financial
companies with market capitalization above $5Bill,
as of 2007-Q2. The chart shows a clear downward
trend in systemic risk for the largest Bank Holding
Companies, with their share in overall capital shortfall
steadily declining post 2012. The reduction in
systemic risk is at least partly explained by their rapid
capital accumulation.
5%
4%
3%
0.6%
0.4%
0.2%
2010-Q1
2011-Q1
2012-Q1
2013-Q1
Source: The Volatility Institute, <http://vlab.stern.nyu.edu/>.
2014-Q1
3. …and are growing slower than their smaller counterparts…
Chart 3 shows asset growth for Bank
Holding Companies with assets above
$100Bill and for Bank Holding Companies
with assets between $5Bill and $100Bill. For
ease of comparison, assets are normalized to
100 at the beginning of the period (2010Q1). Between 2010-Q1 and 2014-Q1, assets
of the largest BHCs grew by 8%, while assets
of smaller Bank Holding Companies grew by
19%. The relatively slow asset growth of the
largest BHCs, combined with their rapid capital
accumulation (Chart 1) and reduction in
systemic risk (Chart 2), points to the trade-off
between financial stability and asset growth.
Smaller BHCs
120
115
110
105
100
2010-Q1
2011-Q1
2012-Q1
2013-Q1
2014-Q1
Source: FR Y-9C.
4. …reflecting the trade-off between capital accumulation and asset growth.
Chart 4 shows the correlation between capital
accumulation and asset growth between 2010Q1 and 2014-Q1 for Bank Holding Companies
with assets above $100Bill. Each circle
represents a different Bank Holding Company.
The size of each circle is proportional to assets
size, with larger circles representing larger Bank
Holding Companies. The dashed line marks the
negative relationship between capital growth
and asset growth (the correlation is statistically
significant), quantifying the trade-off between
capital accumulation and asset growth.
80%
60%
40%
20%
0
-20%
0
Source: FR Y-9C.
2ppt
4ppt
6ppt
8ppt
Change in CET1 Risk-Based Ratio (2010Q1-2014Q1)
49
I
It has been some time since we were last governed by a Republican-controlled Congress
and a Democratic president. The last time was nearly fifteen years ago during the final six
years of the Clinton Administration. Almost no one expects the next two years to yield the
same legislative results as did that previous experiment in divided government. In fact, for a
variety of reasons, not the least of which is the looming 2016 presidential election, it seems
rather unlikely that the incoming 114th Congress will be as productive as any of those
previous Congresses, measured in terms of enacted legislative output. Indeed, conventional
wisdom (both inside and outside the Beltway, it would seem) holds that the next two years
portend an extended and bitterly partisan political stalemate that will stymie any prospect
for enactment of financial services legislation.
Call me a contrarian, but I take a different view.
Despite the partisan politics that will inevitably
animate both ends of Pennsylvania Avenue over the
next two years, there will be opportunities in the new
Congress to enact meaningful (albeit targeted and
incremental) financial services legislation.
There are several potential procedural paths to
enactment of such legislation. For example, there
has been a lot of chatter in Washington recently
about Congressional Republicans using the “budget
reconciliation” process to circumvent Democratic-led
filibusters in the Senate. There is also talk of attaching
GOP legislative riders to appropriations bills and other
“must-pass” legislation. But with Senate Republicans
still short of a filibuster-proof majority and a Democratic
president armed with a veto pen, the most likely avenue
for enactment of financial services-related legislation in
the new Congress will involve regular procedural order
and bipartisan compromise. As discussed below, there
50
are already a few legislative proposals percolating on
Capitol Hill around which a bipartisan consensus seems
to be emerging.
The new Congress is also likely to feature vigorous
– and now bicameral – Congressional oversight of the
Obama Administration and the financial regulatory
agencies, which could be particularly impactful with
respect to the ongoing regulatory implementation of the
Dodd-Frank Act.
Even if this optimistic outlook on the prospects for
legislative action turns out to be Pollyannaish, the results
of this month’s mid-term elections are certain to alter
the balance of power with respect to executive branch
nominations.
Each of these topics is discussed in more detail below,
with a focus on the possible legislative and oversight
agendas of the key Congressional committees that
exercise jurisdiction over the financial services industry.
The Art
of the
Possible
Prospects for Financial Services
Legislation in the 114th Congress
 by Samuel Woodall III, Partner, Sullivan & Cromwell LLP
51
The Art of the Possible: Prospects for Financial Services Legislation in the 114th Congress
Post-Election Landscape on Capitol
Hill
The new GOP majority in the Senate and the newlybuttressed Republican majority in the House are now
poised to pursue a single legislative agenda, one that
will likely focus on “big ticket” issues like energy policy
and perhaps corporate tax reform. But Congressional
Republicans will also have the opportunity to do
something that has been off-limits for the last several
years: amend Dodd-Frank.
‘‘
Despite the partisan politics that
will inevitably animate both ends of
Pennsylvania Avenue over the next two
years, there will be opportunities in
the new Congress to enact meaningful
financial services legislation.
52
Frank.1 The House of Representatives subsequently
approved a companion bill by a bipartisan majority.2
With near unanimous support in both chambers,
coupled with recent testimony by Federal Reserve Board
Governor Dan Tarullo, who said enactment of this
legislation “would be very welcome,”3 it appears likely
to be fast-tracked and reach President Obama’s desk
during the “lame duck” session of the current Congress.
Although admittedly technical in nature and targeted
in scope, enactment of this legislation could presage a
willingness on the part of Senate Democrats to entertain
other, targeted amendments to Dodd-Frank in the new
Congress.
Senate Banking Committee
Senator Richard Shelby (R-AL), who previously led
the Banking Committee from 2003 to 2007, is poised
to reassume the committee gavel for the remaining two
years he is permitted to serve under the term limits
imposed by Senate GOP rules. Under his leadership, the
Committee will pursue a different set of legislative and
oversight priorities than it did under the stewardship
of outgoing Chairman Tim Johnson (D-SD), who has
consistently supported the Obama Administration’s
financial reform efforts and generally opposed
amendments to Dodd-Frank (with the exception of the
Collins Amendment legislation mentioned above).
Since the enactment of the Dodd-Frank Act in 2010,
the Obama Administration and its Democratic allies
in the Senate have consistently and vigorously opposed
legislation that would amend the Act. So resolute have
Democrats been in defense of this position that some
have described it as the political equivalent of the “11th
Commandment: Thou Shalt Not Amend Dodd-Frank.”
Like his predecessor, Chairman Shelby’s agenda will
include Dodd-Frank oversight, but led this time by a
staunch opponent of that legislation, which he strongly
More recently, however, Senate Democrats, together
with all of their Republican colleagues, did vote to amend
Dodd-Frank. That unanimous, bipartisan vote occurred
on a bill relating to the treatment of certain insurance
companies under the “Collins Amendment” to Dodd-
1
S. 2270 (the “Insurance Capital Standards Clarification Act of
2014”), available at https://www.congress.gov/113/bills/s2270/
BILLS-113s2270es.pdf.
2
H.R. 5461, available at https://www.congress.gov/113/bills/
hr5461/BILLS-113hr5461rfs.pdf.
3
Daniel K. Tarullo, Member, Board of Governors of the Federal
Reserve System, Dodd-Frank Implementation, Testimony before
the Committee on Banking, Housing, and Urban Affairs, U.S.
Senate, Washington, D.C. (Sept. 9, 2014), available at http://
federalreserve.gov/newsevents/testimony/tarullo20140909a.htm.
denounced in the Banking Committee4 and against which
he voted on final passage. Indeed, Senator Shelby has
repeatedly expressed concerns with Dodd-Frank-mandated
regulations that he considers to be imprudent or unduly
burdensome, including the Volcker Rule.5 Nor is it likely that
he will hesitate to criticize the Obama Administration and
the financial regulators – in particular the Federal Reserve,
of which he has been a frequent and outspoken critic.6
‘‘
Senator Shelby has also been a strong proponent of
requiring regulators to conduct cost-benefit analyses of
new regulations. In 2011, he introduced legislation,7 cosponsored by several Banking Committee Republicans,
that would require regulators to conduct a “qualitative
and quantitative assessment of all anticipated direct and
indirect costs and benefits” of any proposed regulation,
including compliance costs, effects on “job creation,”
“regulatory administrative costs,” and any costs the
regulation might impose on state and local governments.
This emphasis on cost-benefit analysis is likely to be a
signature aspect of his agenda as chairman.
4
Statement of Senator Richard Shelby, Senate Banking Committee,
Executive Session to Mark-up an Original Bill Entitled “Restoring
American Financial Stability Act of 2010” (March 22, 2010),
available at http://www.banking.senate.gov/public/index.
cfm?FuseAction=Files.View&FileStore_id=96cabd7f-a4df-4e02be38-e14d25c4c59f.
5
Hearing before the Committee on Banking, Housing, and Urban
Affairs, U.S. Senate, 111th Congress – 2nd Session, Examining
Recent Restrictions placed on Commercial Banks and Bank
Holding Companies’ High-Risk Investment Activities (Feb. 2,
2010), available at http://www.gpo.gov/fdsys/pkg/CHRG111shrg57709/html/CHRG-111shrg57709.htm. See Statement
of Senator Richard Shelby: “…there does not seem to be evidence
that . . . that proprietary trading created the losses that resulted in
the rate need and race for bailouts.”
6
Brandon Moseley, Shelby Says that Federal Reserve has Engaged
in “A Backdoor Stimulus Program through Monetary Policy,”
Alabama Political Reporter (Jan. 9, 2014), available at http://
alreporter.com/archives/2012-september/146-state/5581shelby-says-that-federal-reserve-has-engaged-in-a-backdoorstimulus-program-through-monetary-policy.html. “I have long
been concerned that this aggressive and extraordinary purchasing
program is artificially propping up home prices. This is especially
pertinent since an over-heated housing market greatly contributed
to the financial crisis that caused this situation in the first place.”
7
Like his predecessor, Senator Shelby has consistently
expressed concerns with the regulatory burden
imposed on community banks and may, as he has in
the past,8 seek to advance a package of “regulatory
relief ” measures intended primarily to benefit smaller
banking organizations. At times, however, he has also
been a harsh critic of the largest banks, perhaps most
notably during the Dodd-Frank legislative debate when
he voted for the Volcker Rule and cast one of only three
Republican votes in favor of an amendment offered
by Senators Kaufman (D-DE) and Brown (D-OH) that
would have effectively broken up the largest banking
S.1615 (the “Financial Regulatory Responsibility Act of 2011”),
available at https://www.congress.gov/112/bills/s1615/BILLS112s1615is.pdf.
Congressional Republicans
will also have the opportunity to do
something that has been off-limits
for the last several years: amend
Dodd-Frank.
organizations in the United States.9 Moreover, in 1999,
he voted against the Gramm-Leach-Bliley Act, the
legislation that partially repealed the Glass-Steagall Act’s
separation of commercial and investment banking. He
has also suggested, on more than one occasion, that
capital standards should be higher for the largest banks.10
8
Id.
9
U.S. Senate Roll Call Vote #136, 111th Congress – 2nd
Session (May 6, 2010), available at http://www.senate.
gov/legislative/LIS/roll_call_lists/roll_call_vote_cfm.
cfm?congress=111&session=2&vote=00136. The amendment
failed by a vote count of 33 to 61.
10 Hearing before the Committee on Banking, Housing, and Urban
Affairs, U.S. Senate, 112th Congress – 2nd Session, Implementing
Wall Street Reform: Enhancing Bank Supervision And Reducing
Systemic Risk (June 6, 2012), available at http://www.gpo.gov/
fdsys/pkg/CHRG-112shrg78813/pdf/CHRG-112shrg78813.pdf.
53
One issue on which Senators Shelby and Johnson
strongly disagree is housing finance reform. Describing
the issue as the Committee’s “top priority,”11 Chairman
Johnson and Ranking Minority Member Mike Crapo
(R-ID) brokered an agreement earlier this year with a
bill that would have eliminated Fannie Mae and Freddie
Mac and established a new housing finance regulator
and backstop guarantor.12 Although approved by the
committee with some Republican support, Senator
Shelby voted against the measure, arguing that it would
“complicate an already complex problem by expanding
the role of the federal government in our private housing
finance market and creating, yet again, another massive
regulator.”13 In this regard, Senator Shelby’s position on
the issue of housing finance reform is more aligned with
that of current House Financial Services Committee
Chairman Jeb Hensarling (R-TX).14 Given the continued
divisiveness of this issue in Congress, the ongoing
recovery of the housing markets in the U.S., and the very
limited window of opportunity to develop, debate, and
pass major legislation in advance of the 2016 presidential
and Congressional elections, passage of comprehensive
housing finance reform legislation does not appear to be
in the cards in the 114th Congress.
Even if Senate Republicans maintain their majority
after the 2016 elections, as noted above, Senator Shelby
can only serve as chairman of the Banking Committee for
two more years, which leaves precious little time to see
new legislation through to enactment, especially against
11 Senate Banking Committee, Johnson, Crapo Continue Work on
Housing Finance Reform (Feb. 5, 2014), available at http://www.
banking.senate.gov/public/index.cfm?FuseAction=Newsroom.
PressReleases&ContentRecord_id=27117999-d992-2666-eb7316d9b210a581.
12 Senate Banking Committee, Johnson, Crapo Continue Work on
Housing Finance Reform (Feb. 5, 2014), available at http://www.
banking.senate.gov/public/index.cfm?FuseAction=Newsroom.
PressReleases&ContentRecord_id=27117999-d992-2666-eb7316d9b210a581.
54
the backdrop of divided government. Accordingly,
Chairman Shelby will likely be inclined to prioritize
regulatory burden relief for smaller banks, although
as discussed below, such legislation could potentially
include some targeted relief for the larger banks.
House Financial Services Committee
With Republicans still in firm control of the House of
Representatives and leadership of the House Financial
Services Committee expected to remain largely intact,
the financial services agenda on the House side of the
Capitol is likely to resemble in many respects the agenda
Chairman Hensarling has pursued in his committee over
the last two years. In stark contrast to the Senate, the
House has passed literally dozens of bills over the last four
years that would amend Dodd-Frank, with the Financial
Services Committee approving more than 30 such bills in
the 113th Congress alone, none of which has advanced in
the Senate. Obviously, it should be easier for Chairman
Hensarling to get the Senate Banking Committee’s
attention beginning next year.
The Financial Services Committee has also conducted
numerous Dodd-Frank oversight hearings in the 113th
Congress, during which the panel’s Republican members
have been harshly critical of the Obama Administration,
the federal banking agencies, and the Financial Stability
Oversight Council (FSOC), scrutiny that will only
intensify now that the GOP is the majority party on
both sides of the Capitol. The harshest of this bicameral
scrutiny is likely to be reserved for the Consumer
Financial Protection Bureau (CFPB), an agency
Senator Shelby has described as the “most powerful yet
unaccountable bureaucracy in the federal government”15
and Chairman Hensarling has characterized as the
“single most unaccountable agency in the history of
America.”16 Accordingly, Congressional Republicans will
13 Senator Richard Shelby, Shelby Opposes Massive New Regulator
and Taxpayer Exposure in Housing Regulation Bill (May 15, 2014),
available at http://www.shelby.senate.gov/public/index.cfm/
newsreleases?ID=50559536-37c2-41d4-9067-09894d4477ab.
15 Senator Richard Shelby, The Danger of an Unaccountable
‘Consumer-Protection’ Czar, Wall Street Journal (July 21, 2011),
available at http://online.wsj.com/news/articles/SB1000142405
3111903554904576457931310814462.
14 H.R. 2767 (the “Protecting American Taxpayers and Homeowners
Act of 2013”), available at https://www.congress.gov/113/bills/
hr2767/BILLS-113hr2767ih.pdf.
16 James Freeman, What If Republicans Win?, Wall Street Journal
(Oct. 17, 2014), available at http://online.wsj.com/articles/theweekend-interview-what-if-republicans-win-1413585182.
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almost certainly direct at least one legislative broadside
at the governance, funding, and operation of the CFPB.
That sort of legislation is very unlikely to make it through
to enactment, however.
In addition to viewing the Dodd-Frank Act as a
hindrance to economic growth, House Republicans
generally remain skeptical that the law has achieved
(or will ever achieve) its stated objectives of ensuring
financial stability and ending “too-big-to-fail.” The
latter concern has been a particular focus of committee
activity under Chairman Hensarling. On the fouryear anniversary of the Act’s enactment, committee
‘‘
Proposals to raise or otherwise
modify the SIFI asset threshold have
already been endorsed on a bipartisan
basis in the House and appear to be
gaining support in the Senate.
Republicans issued a staff report concluding that “not
only did the Dodd-Frank Act not end ‘too-big-to-fail,’ it
had the opposite effect of further entrenching it as official
government policy.”17 In particular, the report’s authors
cast doubt on the credibility of the resolution plans (or
“living wills”) mandated under Dodd-Frank and allege
that, rather than ending “too-big-to-fail” (TBTF) the
Orderly Liquidation Authority (OLA), codified in Title II
of Dodd-Frank, has become a “fixture in the regulators’
17 Failing to End “Too Big to Fail”: An Assessment of the DoddFrank Act Four Years Later, Report Prepared by the Republican
Staff of the Committee on Financial Services, U.S. House of
Representatives (July 2014), available at http://financialservices.
house.gov/uploadedfiles/071814_tbtf_report_final.pdf.
56
toolkit, . . . subverting market discipline and making
future bail-outs more (not less) likely.”18
Chairman Hensarling has pledged to pursue a package
of TBTF-related provisions,19 potentially including the
repeal of the OLA, various FSOC-related measures, and
additional limits on the Federal Reserve’s “lender of last
resort” authority. The proposed repeal of the OLA could
conceivably be joined with a broader proposal, now
pending in the House Judiciary Committee, to modify
the Bankruptcy Code to facilitate the orderly resolution
of large financial institutions.
Financial Services Legislation That
Could Advance in the New Congress
So exactly what kind of targeted banking legislation
might advance in the new Congress? The leading
contenders for now appear to be proposals to modify
the current statutory threshold of $50 billion in total
assets at which bank holding companies become
subject to “enhanced prudential standards” (regarding
capital, liquidity, risk-management) and regulation as
“systemically-important financial institutions” (SIFIs).20
Proposals to raise or otherwise modify the SIFI asset
threshold have already been endorsed on a bipartisan
basis in the House21 and appear to be gaining support in
the Senate. Senior regulators have also expressed support
for revisiting the SIFI threshold. Most notably, Governor
Dan Tarullo has proposed raising the threshold to $100
billion, arguing that mandatory resolution planning,
18 Id, at 59-60.
19 Jeb Hensarling, Chairman, House Financial Services Committee,
Dodd-Frank Results in Less Freedom, Less Opportunity and a Less
Dynamic Economy, Remarks at a Mercatus Center-CATO Institute
Conference (July 16, 2014), available at http://financialservices.
house.gov/news/documentsingle.aspx?DocumentID=388236.
“Our Committee will also soon take legislative action to end DoddFrank’s bailout fund and bring to an end the reign of those that are
to Too Big to Fail.”
20 Dodd-Frank Act § 165(a)(1)
21 H.R. 4060 (the “Systemic Risk Designation Improvement Act of
2014), available at https://www.congress.gov/113/bills/hr4060/
BILLS-113hr4060ih.pdf and H.R. 4532, available at https://www.
congress.gov/113/bills/hr4532/BILLS-113hr4532ih.pdf.
stress-testing and other regulations “do not seem . . . to
be necessary” for banks with between $50 billion and
$100 billion in total assets.22 Similarly, Comptroller of
the Currency Tom Curry has questioned the utility of the
$50 billion “bright line,” and has suggested that a more
sensible approach would be to “use an asset figure as a
first screen and give discretion to the supervisors based
on the risks in their business plan and operations.”23
Even former Rep. Barney Frank recently endorsed the
concept in testimony before the committee he previously
chaired.24
Modifying the SIFI size threshold has recently been
the focus of a legislative effort in the House Financial
Services Committee, where two leading proposals have
been considered. The first, a bill sponsored by Rep. Blaine
Luetkemeyer (R-MO)25 and co-sponsored by 77 others
(58 Republicans and 19 Democrats), would eliminate the
automatic asset threshold altogether and instead require
the FSOC to apply an “indicator-based measurement
approach,” which considers several factors in addition
to size, to assess systemic importance. A second bill,26
authored by Rep. Joyce Beatty (D-OH) and co-sponsored
by Rep. Steve Stivers (R-OH), would direct the FSOC to
review banks with total assets of between $50 billion and
$250 billion in order to determine whether to subject
these firms to enhanced prudential standards and
supervision, and expresses the “sense of Congress that
consolidated asset size remains a factor, but only one of
many factors, that should be considered in determining
22 Daniel K. Tarullo, Member, Board of Governors of the Federal
Reserve System, Rethinking the Aims of Prudential Regulation,
Remarks at the Federal Reserve Bank of Chicago Bank Structure
Conference, Chicago, IL (May 8, 2014), available at http://www.
federalreserve.gov/newsevents/speech/tarullo20140508a.pdf.
23 Rachel Witkowski, Curry: $50B Cutoff Alone Is Inadequate to
Gauge Banks’ Risk, American Banker (Sept. 23, 2014), available
at http://www.americanbanker.com/issues/179_184/curry-50bcutoff-alone-is-inadequate-to-gauge-banks-risk-1070157-1.html.
24 House Financial Services Committee, Hearing Entitled “Assessing
the Impact of the Dodd-Frank Act Four Years Later” (July 23,
2014), available at http://financialservices.house.gov/calendar/
eventsingle.aspx?EventID=388239.
systemic risk.”27 Although these legislative proposals did
not make it out of committee during this Congress, they
seem to underscore a growing, bipartisan consensus that
Congress should revisit the SIFI threshold.
While no comparable legislation has advanced to
date in the Senate, the idea of raising the SIFI threshold
has begun to garner some interest on both sides of the
aisle. Notably, Sen. Sherrod Brown (D-OH), who could
serve as the Ranking Minority Member on the Banking
Committee next year, has criticized the $50 billion asset
threshold as an approach that treats regional banks
operating under a “traditional banking model” whose
failure would not “threaten the U.S. or global financial
system” the same as larger, more complex institutions.28
In addition, he has underscored the need for regulators to
examine the systemic risk posed by banks’ size, leverage,
and business model on a case-by-case basis and to “strike
the right balance between identifying institutions and
activities that present the most risk.”29
With lawmakers and regulators alike now
acknowledging that the contours of the SIFI universe,
as defined in Dodd-Frank, are overly broad, it may be
possible for legislation amending the SIFI threshold to
advance in the new Congress, to serve as a vehicle for
advancing targeted relief for smaller banks, and potentially
to include additional provisions that could provide some
limited relief for larger banks (e.g., with respect to the
Dodd-Frank derivatives “push-out” requirement). It is also
possible that various “FSOC reform” proposals could find
their way into such a legislative package.
One possible starting point for a bipartisan discussion
in the Senate regarding possible amendments to DoddFrank might be legislation Senator Shelby introduced
in early 2013 consisting exclusively of purely technical
27 Id, at 12.
25 H.R. 4060.
28 Senate Banking Committee, Hearing Entitled “What Makes A Bank
Systemically Important?” (July 16, 2014), available at http://
www.banking.senate.gov/public/index.cfm?FuseAction=Hearings.
Hearing&Hearing_ID=7d743184-d3e5-4ee7-8d41ab4d846f7457.
26 H.R. 4532.
29 Id.
57
corrections to Dodd-Frank (e.g., statutory typos,
imprecise cross-references, etc.).30
Governor Tarullo has proposed tailoring existing
and forthcoming regulatory requirements according
to banks’ size, scope, and range of activities, noting
that certain existing regulatory requirements may be
“disproportionately costly for community banks.”31 He
has also suggested that it may be “worthwhile to have
a policy discussion of statutes that might be amended
explicitly to exclude community banks” with less than
$10 billion in total assets, particularly citing the Volcker
Rule and the incentive compensation requirements
imposed under Sec. 956 of the Dodd-Frank Act.32 Both
of these suggestions could also find their way into new
legislation.
Finally, there is a substantial risk that financial services
legislation – in particular, punitive measures targeting
the largest banks – could advance in the Senate outside
of the committee process, especially if incoming Majority
Leader Mitch McConnell (R-KY) follows through on
his pledge to provide for a “free and open amendment
process” on the Senate floor.33
The Congressional Bully Pulpit
Even if a two-year legislative stalemate ensues, the
new Republican-controlled Congress will nonetheless
have a significant impact on financial services regulation
and policy through use of the “bully pulpit” that
Congressional oversight confers. This can be an especially
influential platform when the same party controls
both chambers of Congress and could be particularly
significant with respect to the regulatory agencies’
ongoing implementation of Dodd-Frank.
30 S.451 (the “Dodd-Frank Wall Street Reform and Consumer
Protection Technical Corrections Act of 2013”), available at
https://www.congress.gov/113/bills/s451/BILLS-113s451is.pdf.
31 Tarullo, at 13.
32 Id, at 11.
33 Sarah Mimms, What to Expect From Mitch McConnell’s Senate,
National Journal (Nov. 5, 2014), available at http://www.
nationaljournal.com/congress/what-to-expect-from-mitchmcconnell-s-senate-20141105.
58
In addition to jaw-boning regulators to tailor the
application of automatic SIFI regulation for covered
insurance companies and smaller banks, the Republicanled oversight committees are likely to weigh in on
implementation of the Volcker Rule. Indeed, the current
Congress was instrumental in pressuring the regulators
to adopt special rules regarding the application of the
Volcker Rule to certain collateralized debt obligations,34
and it seems likely this trend will continue in the
new Congress, especially in light of the approaching
expiration of the Volcker Rule “conformance period.”
For example, the House has passed legislation addressing the treatment of certain collateralized loan obligations
(CLOs) on three different occasions, once on a stand-alone
basis and twice coupled with separate policy proposals,
clarifying that the Volcker Rule does not require banking organizations to divest, prior to July 21, 2017, CLO
debt securities issued before Jan. 31, 2014.35 In what may
constitute the nascent stage of another bipartisan Volcker
Rule-related initiative on Capitol Hill, three Democrats
on the House Financial Services Committee – Gary Peters
(MI), John Carney, Jr. (DE), and Dennis Heck (WA) – recently sent a letter urging the Federal Reserve to “streamline the process” for banking entities to avail themselves of
the seven-year conformance period for certain investments in legacy venture capital and private equity funds.36
As the July 21, 2015 expiration of the existing conformance period approaches, the new Congress is likely to be
34 Joint Press Release, Board of Governors of the Federal Reserve
System, Commodity Futures Trading Commission, Federal Deposit
Insurance Corporation, Office of the Comptroller of the Currency,
Securities and Exchange Commission, Agencies Approve Interim
Final Rule Authorizing Retention of Interests in and Sponsorship of
Collateralized Debt Obligations Backed Primarily by Bank-Issued
Trust Preferred Securities (Jan. 14, 2014), available at http://
federalreserve.gov/newsevents/press/bcreg/20140114b.htm.
35 See H.R. 4167 (the “Restoring Proven Financing for American
Employers Act”), available at https://www.congress.gov/113/
bills/hr4167/BILLS-113hr4167rfs.pdf; H.R. 5405 (the “Promoting
Job Creation and Reducing Small Business Burdens Act”),
available at https://www.congress.gov/113/bills/hr5405/BILLS113hr5405rfs.pdf, and H.R. 5461, available at https://www.
congress.gov/113/bills/hr5461/BILLS-113hr5461rfs.pdf.
36 Letter from Representatives Gary Peters, John Carney, Jr., and Dennis
Heck, Members, House Financial Services Committee, to Scott
Alvarez, General Counsel, Federal Reserve Board (Aug. 7, 2014).
active on Volcker Rule-related issues both in an oversight
capacity and potentially through new legislation.
Executive Branch Nominations
Finally, the Senate’s new Republican majority is
sure to have a significant impact on both pending
and forthcoming executive branch nominations, with
President Obama’s nominees likely to face even greater
scrutiny. As a result of Senate Majority Leader Harry
Reid’s (D-NV) invocation of the so-called “nuclear
option” in November 2013, only a simple majority, rather
than a filibuster-proof 60-vote super majority, is now
‘‘
A complete and utter government
stalemate is not in anyone’s enlightened
self-interest – neither that of the country
as a whole, nor that of a president
contemplating his second-term legacy,
nor that of the incoming Republican
majority on Capitol Hill.
needed to confirm most executive branch nominations,
a rule change the incoming GOP majority seems unlikely
to revisit (although they decried the change at the time).
This new dynamic is likely to be on display early in
the new Congress, when the Senate will consider the
president’s nominees to fill several significant positions
at the Treasury Department and on the Federal Reserve
Board.
60
Conclusion
The next two years in Washington are certain to be
replete with partisan skirmishing – no doubt about that.
And chances are that, before the 114th Congress has
adjourned, President Obama will have used his veto pen
on more than one occasion. Yet, a complete and utter
government stalemate is not in anyone’s enlightened
self-interest – neither that of the country as a whole, nor
that of a president contemplating his second-term legacy,
nor that of the incoming Republican majority on Capitol
Hill. House Majority Leader Kevin McCarthy (R-CA) was
recently quoted in the press as saying “I do know this ...
If we don’t capture the House stronger, and the Senate,
and prove we can govern, there won’t be a Republican
president in 2016.”37 Similarly, on election night, Senator
Mitch McConnell struck a similar tone, arguing that
Republicans and Democrats “have an obligation to work
together on issues where we can agree.”38
Clearly, Democrats and Republicans will seek to
distinguish themselves and their political philosophies
and agendas in advance of the 2016 elections, and
some of that will likely spill over into financial services
legislation. But there will also be opportunities for
targeted, incremental financial services legislation to
advance in the next Congress, especially if lawmakers
from both parties begin to coalesce around targeted fixes,
such as those described above. 
37 Jake Sherman, Exclusive: Kevin McCarthy vows change on Hill
to save GOP, POLITICO (Oct. 26, 2014), available at http://
www.politico.com/story/2014/10/kevin-mccarthy-congressrepublicans-112209.html.
38 Alexander Burns, GOP takes control of Senate in midterm rout,
POLITICO (Nov. 4, 2014), available at http://www.politico.com/
story/2014/11/election-update-midterms-2014-house-senateraces-112491.html?hp=f1.
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Margin for Error
Balancing the Risks and
Benefits of Uncleared Swaps
T
 by D
onna Parisi, Partner, and
Barnabas Reynolds, Partner, Shearman & Sterling LLP
To ensure that systemic concerns arising from counterparty risks associated with uncleared derivatives are
sufficiently managed through collateral, the G20 added margin requirements for such derivatives to the list of post
credit crunch reforms in July 2011.
The rules are designed to reduce counterparty credit risk, limit contagion, and incentivize the central clearing
of derivatives trades. The reliance on collateral rather than capital charges to achieve these goals ensures that the
defaulting party bears the loss, rather than the performing counterparty. The uncleared over-the-counter space,
however, will continue to be very sizeable given that many derivatives are ineligible for central clearing due to
insufficient standardization or liquidity, or because of valuation challenges.
The rules, focusing on the bilateral exchange of margin, could potentially fuel negative outcomes such as regulatory
arbitrage and put yet more pressure on sourcing good quality collateral, which could in turn create space for lessregulated entities to occupy. Further, the proposed new rules threaten to introduce new forms of legal uncertainty into
the cross-border transactional environment, some of which are very significant indeed and not easy to mitigate.
62
International Initiatives
In September 2013, the Basel Committee on Banking
Supervision and International Organization of Securities
Commissions released their final framework for margin
requirements for non-centrally cleared derivatives
transactions.1 The framework sets out eight key
principles and aims to ensure harmonization of their
implementation across multiple jurisdictions. While
the final framework is not binding on any regulatory
authorities, it informs the approach of national
regulators as they adopt their respective margin regimes.
regulators, the proposed rules would apply to all
non-centrally cleared swap activity2 (i.e., swaps and
security-based swaps) without reference to whether the
registrant’s status relates to transactions in one or both
swap product categories.3
The BCBS-IOSCO rules require the bilateral exchange
of initial margin (IM) and the delivery by one party to
the other of variation margin (VM) and apply to financial
firms and systemically important non-financial entities
(“covered entities”), the definitions for which are left to
national regulation.
In Europe, draft regulatory technical standards,
closely following BCBS-IOSCO and implementing the
relevant provisions of the European
Market Infrastructure Regulation
were published by the European
Supervisory Authorities for comment
in April 2014 and are expected to be
finalized by the end of the year.
In September 2014, U.S. banking
regulators and the Commodity
Futures Trading Commission
took steps to adopt revised rule
proposals modeled closely on the
BCBS-IOSCO framework that
would apply to swap registrants
under their respective remits.
In the case of swap registrants
subject to the jurisdiction
of any of the U.S. banking
1
IOSCO recently published a consultation on proposed risk
mitigation techniques (apart from margin) for uncleared
derivatives. The proposals would apply to the same covered
entities as the margin requirements and aim to facilitate the
management of counterparty credit risk and to increase legal
certainty. The proposals are broadly similar to the rules already
implemented in the E.U. and the U.S. However, there are some
key differences. For example, the trade confirmation requirements
apply to non-systemically important non-financial counterparties
in the E.U. but not in the U.S. There are also differences between
the U.S. and E.U. approach to the material terms that need to be
reconciled. Differences in implementation across jurisdictions may
create compliance issues and the industry will need to have robust
systems in place to capture all jurisdictional requirements.
2
The CFTC proposed rulemaking would expand the definition of
“cleared swap” to include swaps that are cleared by certain
clearing organizations not registered with the CFTC as a
“derivatives clearing organization.” Failure to adequately revise this
definition could lead to serious market fragmentation or disruption
as persons subject to the CFTC’s swaps requirements could
potentially remain subject to the U.S. margin regime for uncleared
swaps for a swap cleared at a clearing organization that is not a
registered derivatives clearing organization. The CFTC requested
comment on this point.
3
As used in this article, the term “swap” refers to both swaps and
security-based swaps.
63
Margin for Error: Balancing the Risks and Benefits of Uncleared Swaps
Key Aspects of the Margin Requirements
Parties
Subject to the
Obligations
BCBS-IOSCO
U.S.
E.U.
Financial firms
Swap dealers
Financial counterparties
Systemically important non-financial entities
Security-based swap dealers
IM obligations apply when a covered entity’s
gross notional outstanding group exposure
exceeds €8 billion.
Major swap participants
Non-financial counterparties that exceed the
EMIR clearing thresholds. The clearing thresholds, in gross notional value, are €1 billion for
credit and equity derivatives and €3 billion for
interest rate swaps, foreign exchange, commodity and other OTC derivatives.
Major security-based swap participants
(each, a “swap registrant”).
IM margin requirements apply to transactions between swap registrants as well as
a swap registrant and a financial end-user
where the financial end-user has an
aggregate gross notional exposure under
all its uncleared swaps (including foreign
exchange swaps and forwards) exceeding
$3 billion. VM obligations apply even where
the financial end-user’s exposure does not
exceed the $3 billion threshold.
IM requirements only apply if the €8 billion
threshold is reached.
A quirk of the E.U. proposal, as drafted, is that
it appears to apply to all non-E.U. non-financial entities, whereas E.U. corporates are only
within scope if they exceed the EMIR clearing
threshold.
Margin obligations are not mandatory for
transactions involving non-financial end
users.1
Transactions
Within Scope
Non-centrally cleared derivative transactions between two covered entities, except for physically
settled foreign exchange swaps and forwards.
Same as the BCBS-IOSCO framework.
Same as the BCBS-IOSCO framework, except
that the exemption for physically settled foreign
exchange swaps and forwards only applies to IM
requirements.
Bilateral
Exchange of
Margin
IM to be posted gross on a counterparty portfolio basis and on a bankruptcy-remote basis.
Same as the BCBS-IOSCO framework.3
Same as the BCBS-IOSCO framework. Requirement for bankruptcy-remote posting of IM
prevents continuation of E.U. market practice for
title transfer, introducing significant new legal
uncertainties surrounding the less developed
classes of security interest (including “pledge”).
Deadline for
Implementation4
IM requirements phased-in from December 1,
2015 to December 1, 2019. From December
1, 2019, IM required where gross notional outstanding group exposure exceeds €8 billion.
VM may be posted net, and must be posted with
sufficient frequency (e.g. daily).2
Compliance with VM requirements as of December 1, 2015.
Only applies to contracts entered into after the
applicable date.
Re-hypothecation of Margin
Cash and non-cash VM may be re-hypothecated.
IM should not be re-hypothecated except in
limited circumstances and may only be re-hypothecated once.
Same as BCBS-IOSCO save that the re-hypothecation of IM will be prohibited.
Same as BCBS-IOSCO save that the re-hypothecation of IM will be prohibited.
De Minimis
Thresholds
De minimis threshold for IM of €50 million (c.
$65 million) on a group consolidated basis for
all uncleared derivatives between two consolidated groups.
No threshold for VM.
De minimis minimum transfer amount of
€500,000.
The feasibility of allocating the IM threshold
across entities within a corporate group remains
uncertain.
64
Calibration of
Margin
BCBS-IOSCO
U.S.
E.U.
IM calculated using either a quantitative portfolio or a standardized margin schedule.
Same as the BCBS-IOSCO framework but
specify a one- to five-year historical observation period.
Same as the BCBS-IOSCO framework except
that those using internal models must input
data covering a minimum period of three years.
Exposures within designated risk categories
can be netted prior to calculating the required
margin.
The calibration of IM is based on what is
required, at 99 percent confidence levels, for
liquidation of a position over a 10-day horizon
using historical data. The data must incorporate
a five-year stress period.
IM models subject to quantitative and
qualitative requirements. The U.S. banking
regulators propose articulated standards
similar to those required for proprietary
models used for internal regulatory capital
monitoring purposes.
Dispute mechanisms required for differences
between models.
Inter-Affiliate
Transactions
Defers to local rule-makers to determine
application.
No exemption for inter-affiliate swaps,
which raises concerns about the ability of
corporate groups to pursue internal risk
management strategies.
Intra-group transactions in a financial or
non-financial group are exempt provided certain
conditions are met. Financial groups need
approval of regulator.
Exempt Entities
Sovereigns, central banks, multilateral development banks, the Bank for International
Settlements and non-systemic non-financial
firms. Transactions between a covered entity and
an exempt entity are exempt.
Same as the BCBS-IOSCO framework but
includes an exemption for covered bond issuers,
recognizing that they are not set up to post
margin.
Eligible Collateral for
Margin
National regulators to develop list of eligible
assets. Examples include cash, government
and central bank securities, corporate bonds,
covered bonds, equities, and gold. Assets to be
highly liquid and, after appropriate haircuts are
applied, able to hold their value in a time of
financial stress. Collateral should not include
securities issued by the counterparty or its
related entities.
Generally the same as the BCBS-IOSCO
framework.
Generally the same as the BCBS-IOSCO framework, except that the use of senior securitization
tranches and units in retail funds known as
undertakings for the collective investment in
transferable securities (“UCITS”) is permitted,
which will likely require larger haircuts while
reducing pressure on government bonds.
Securities issued by financial institutions
not eligible.
Additional haircut of 8 percent for currency
mismatch.
Securities issued by financial institutions not
eligible.
Additional haircut of 8 percent for currency
mismatch.
4
For swaps with non-financial end users, the proposed rulemaking of the U.S. banking regulators would require swap registrants to collect IM
or VM only at such times and in such forms as the registrant determines appropriate to address the registrant’s credit risk to the counterparty.
On the other hand, the CFTC proposal includes no margin collection requirement for swaps with a non-financial end-user. Swap registrants
subject to the CFTC’s margin framework would be required to calculate on a daily basis a hypothetical IM and VM amount related to such swaps
where it has material swaps exposure as a risk management measure. The CFTC also proposes additional trading relationship documentation
requirements whereby the governing agreement must specify whether IM or VM will be exchanged, transaction valuation methodology and
data sources for such purpose as well as provide for dispute resolution mechanics. The divergent approaches stem from the CFTC’s adherence
to pronouncements of the U.S. Congress that non-financial end-users should not be required to post margin for their swaps, and a strict
construction by the U.S. banking regulators of their legislative mandate to adopt margin requirements for the uncleared swap activity of swap
registrants under their jurisdiction.
5
Daily bilateral exchange of VM is likely to prove to be an operationally challenging task for smaller entities and trades across time zones and may
trigger heightened sensitivity among market participants to liquidity management concerns.
6
Note, however, that for purposes of calculating the minimum amount of required IM, the U.S. proposals permit the use of models that take into
account offsetting exposures, diversification, and other hedging benefits for uncleared swaps governed by the same master netting agreement by
reference to empirical correlations within – but not across – specified risk categories.
7
While the EU and U.S. proposals do not require compliance for transactions executed prior to the relevant compliance date, as a practical matter,
the margin requirements will apply retroactively to the extent entities covered by the rules calculate their margin requirements on a portfolio
basis under an eligible master netting agreement that governs transactions executed both prior to and after the effective date of the rules.
65
Impact
The introduction of the requirements presents
significant commercial, operational, and legal challenges.
Availability of Collateral
There are concerns that stricter margin requirements
may have a significant impact on market liquidity
and the availability of collateral, particularly as IM
must be posted gross and cannot be netted or offset
between counterparties. Several quantitative impact
studies have been conducted. An analysis conducted
by the International Swaps and Derivatives Association
‘‘
There are concerns that stricter
margin requirements may have a
significant impact on market liquidity
and the availability of collateral.
estimates that the earlier versions of the BCBSIOSCO framework could see IM requirements reach
a peak of $10.2 trillion (c. €8.04 trillion) if internal
models were not used to make IM calculations and
no counterparty threshold applied. On the other
hand, a study referenced by BCBS-IOSCO projects
that model-based IM calculations could result in
requirements of approximately €1.3 trillion where no
counterparty threshold applies and nearly €600 billion
if a counterparty threshold of €50 million applies. These
estimations rise dramatically to €7.5 trillion and €6.2
trillion, respectively, where calculations are entirely
based on a standardized margin schedule.
66
Rise in Shadow Banking Activity
Given the demand for eligible collateral, the cost of
such collateral is likely to rise. Market participants will
look to exchange non-qualifying securities for eligible
collateral. This collateral transformation activity will
increase repo and securities lending activity, which
will partly be absorbed within the shadow banking
sector. The CFTC has acknowledged that collateral
transformation services might proliferate, but does not
mention the potential risks that this might give rise to.
Moreover, the traditional repo market is under pressure
from Basel III reforms (notably the leverage ratio and the
Net Stable Funding Ratio).
Regulators are taking steps to curb risk in the shadow
banking arena. The Financial Stability Board recently
published its final framework for haircuts on collateral in
uncleared securities financing transactions, as a measure
to thwart the rapid onset of margin calls. The framework
is made up of qualitative standards for methodologies
to calculate haircuts on collateral received and proposed
numerical haircut floors in which financing against
collateral other than certain government securities is
provided to nonbanks. The proposed implementation
date by national authorities is the end of 2017. There will
be significant challenges in implementation, given that
in the U.S. regulation is split among various regulatory
agencies and more entity-based (for instance, by
banks, broker-dealers, systemically important financial
institutions, and asset managers) as opposed to activitybased as it is in Europe.
Infrastructure Needs
Robust systems for the calculation and notification
of margin amounts will be required.8 In addition, new
infrastructure and technology will need to be developed
8
In this regard, the U.S. proposed rules require a swap registrant
to calculate IM and VM not only for transactions subject to the
margin requirements but also hypothetical IM and VM amounts for
positions held by non-financial entities that have material swap
exposure to the swap registrant and compare these hypothetical
requirements to actual requirements. Thus, margin calculations will
apply to a broad swath of a swap registrant’s counterparties, even
if a counterparty is not ultimately required to post margin.
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to facilitate the allocation and monitoring of the €50
million/$65 million threshold across legal entities.
Likewise, it is imperative that the industry adopt and
receive necessary regulatory approval of a common
methodology for the calculation of IM requirements to
promote consistency and minimize the risk of disputes.9
In the absence of a consistent model, the bespoke
calculation of margin amounts by each counterparty
to a trade could result in different amounts being paid,
by counterparties, due to legitimate variations between
models. To this end, ISDA is leading an initiative to
develop a standard IM model (SIMM) for widespread
use by the market. The advantages of this would include
greater predictability in margin requirements.
For pension plans, this may significantly affect fund
performance and the funding of pension obligations.
Predictability of margin requirements is critical to the
consistent pricing of transactions and discouragement
of aggressive models to win business. There are also
different views regarding margin funding costs, with
some institutions pricing on the basis of the term of the
transaction and others on an expected or average life
assumption. Another potential area of inconsistency is
the placement of transactions into risk categories, which
has netting implications as described above. Under
the U.S. proposals, each covered entity selects the risk
category for netting purposes. This may lead to disparate
results where two swap registrants are party to a trade.
Commercial Concerns
There have been a number of commercial concerns
raised by market participants. Financial end-users with
directional portfolios such as pension plans will not
benefit from the limited permitted exposure netting
within risk categories (see Calibration of Margin row
in the table) resulting in higher IM for those end users.
‘‘
Predictability of margin
requirements is critical to the
consistent pricing of transactions and
discouragement of aggressive models
to win business.
9
68
The U.S. proposals reflect an expectation that regulators in
multiple jurisdictions will adopt similar requirements for noncentrally cleared derivatives and contemplate adoption of a
framework permitting non-U.S. swap registrants to comply with
U.S. requirements through compliance with the requirements of
another jurisdiction whose margin regime for non-centrally cleared
derivatives is found by U.S. authorities to be comparable to
equivalent U.S. rules.
The scope of the rules is wide and extends margin
requirements to securitization vehicles, an arguably
unnecessary reach of the rules given the priority swap
counterparties have in securitization payment waterfalls
over and above bond investors. (But it is likely that many
securitizations would fall below the $3 billion threshold).
This is yet another cost constraint on securitization
structures and does not serve to encourage the assetbacked security market, which is an essential pillar for
the full-scale rehabilitation and normalization of the
commercial and retail banking market globally. Under
the E.U. proposals, securitization issuers would also fall
outside scope if the swap exposure of the issuer is less
than the €8 billion threshold. There is also a specific
exemption for covered bond issuers.
Finally, the U.S. regulators have acknowledged that
there may be a discrepancy between the classification
of a counterparty as a non-financial entity for purposes
of determining eligibility for the mandatory clearing
exemption and classification as a non-financial end-user for
the uncleared margin requirements. The discrepancy does
not arise in the E.U. context as the end-user exemption
from clearing is aligned with the exemption from margin
requirements. Under the U.S. proposals, the clearing
exemption for end users could well become irrelevant given
that margin for uncleared trades is likely to be higher than
for the cleared counterparty, which in turn would steer
those end users, falling within the clearing exemption but
within the scope of the margin rules, to the cleared space.
This outcome would not be aligned with the valid reasons
justifying the end-user exemption from central clearing.
A separate significant issue facing U.S. covered
entities is the absence of an exemption for intra-group
transactions. E.U. entities benefit from such an exemption.
The divergence increases the potential for arbitrage. This
issue is entwined with resolution and recovery planning
and has implications from a regulatory capital perspective.
To guard against the risk that their security may
become void or unenforceable, counterparties will
need to undertake an analysis of relevant local laws
on security interests, and manage their practical
arrangements carefully. This of course is likely to involve
some uncertainties, difficult judgment calls (and the
running of risk) and considerable expense. The E.U.
proposals also require a legal opinion verifying that IM is
adequately segregated and insulated from the bankruptcy
risk of the collateral taker. Where IM is in the form
of cash, the cash amount will need to be individually
segregated per each collateral provider with a third party
bank (to whose credit risk the provider is then exposed).
‘‘
Increased Legal Risk and Additional Documentation
Requirements
There are certain legal risk issues that have not been
sufficiently acknowledged or addressed in either of the
proposed U.S. or E.U. rules. As mentioned, IM will have
to be exchanged two-way and gross on a bankruptcyremote basis, and be immediately available to the
collateral taker. The U.S. proposals require the use of
third-party custodial accounts for cash and securities,
buttressed by a security interest or pledge in favor of the
collateral taker. In the E.U., title transfer arrangements,
which currently predominate in the market, will
not meet the requirement that margin be held on a
bankruptcy-remote basis. The margin will have to be
held on a security interest basis and held either with
the collateral provider or with a custodian. E.U. laws on
security interest arrangements are not well developed
and are inadequately harmonized across the E.U.
The E.U. requires collateral to be in the “possession or
control” of the collateral taker to get full protection from
normal insolvency law. The English courts interpret this
as potentially prohibiting the collateral provider from
automatically withdrawing collateral deemed no longer
necessary. So U.S. arrangements where the collateral
provider periodically takes back from the collateral
account excess collateral can present issues in the E.U.,
which seeks to protect the collateral taker to a greater
degree. The market will no doubt use the U.S. style
arrangements globally if at all possible to avoid paying in
IM for longer than required and to avoid having to wait
for a collateral taker to release reimbursement.
There are certain legal risk
issues that have not been sufficiently
acknowledged or addressed in either
of the proposed U.S. or E.U. rules.
With respect to third party custodial arrangements,
custody agreements and account control agreements
will need to be negotiated and put in place with a large
contingent of counterparties. Existing documentation
will need to be modified to contemplate these third
party arrangements. Documentation may also need
to be amended to comply with proposed CFTC rules
requiring that swap trading relationship documentation
include a process for determining the value of each
swap in compliance with the margin requirements.10 It
10 Existing CFTC Regulation 23.504(b) requires a swap registrant to
include in its swap trading relationship documentation methods
and procedures agreed with its counterparty for the valuation of
every swap at any time from execution to termination, maturity,
or expiration of the relevant swap. The explicit objective of the
regulation is facilitation of compliance with each of the CFTC’s risk
management and margin requirements for swap registrants.
69
remains to be seen what this disclosure requirement will
mean in practice, especially with respect to proprietary
risk based margin models. This rule, as is the case
elsewhere, also requires that each swap registrant
establish and maintain policies and procedures to
resolve a valuation discrepancy, including as to how
VM will be handled pending resolution of a dispute.
Additionally, an institution may wish to put in place
separate master netting agreements to avoid having
the margin requirements apply to pre-effective date
transactions since IM and VM requirements will apply
to all transactions under a master netting agreement that
governs post-effective date transactions.
From a risk perspective, while holding collateral with a
custodian mitigates the risk associated with the collateral
receiver’s bankruptcy, it does not eliminate all risk. In the
event of an insolvency of counterparty (or other trigger
for the release of collateral) it may well be that a custodian
will not release the collateral to either party until directed
to do so by a court with competent jurisdiction. It is also
critical to keep in mind that in times of systemic stress,
liquidity may be severely impaired. Additionally, upon
any custodian insolvency, excluding cash collateral from
the bankruptcy estate is very difficult. This requires the
reinvestment of cash into securities on a daily sweep
basis generally. In the E.U., or at least in the U.K., banks
holding cash collateral could recognize the beneficial
interest of the custodian’s client in the cash (strictly the
custodian’s rights as depositor to the cash account). More
broadly, as greater amounts of collateral are held in a
limited number of custodian banks, this will concentrate
risk in the financial system further.
Unless global regulators look again at permitting title
transfer, the netting of IM payments, and expanding the
list of eligible collateral, the effect of the rules for IM may
simply be to swap counterparty risk for legal risk and
uncertainty at an international level.
Extraterritorial Application
Another chief concern is the extraterritorial
application of the regime for cross-border transactions,
potentially leading to conflicts in the detailed application
70
of the regime at a local level. A key principle included in
the BCBS-IOSCO framework is that national regulatory
regimes implementing the framework should not lead
to conflicting, duplicative, or inconsistent requirements
for participants; should limit regulatory arbitrage; and
should maintain a level playing field. Both the E.U. and
the U.S. proposed rules allow for substituted compliance,
or compliance with home country requirements
through compliance with local rules, provided that the
relevant margin regime is found to be equivalent to
their respective rules. Both sets of proposed rules also
have extraterritorial reach, although the E.U. proposed
rules are not as wide-reaching as the proposed U.S.
rules. It remains to be seen how many equivalence or
comparability determinations will be issued for the
uncleared margin requirements. In the U.S., consensus
has not been reached and much uncertainty remains
as to the extraterritorial application of Title VII of
Dodd Frank generally. This, combined with a lack
of resources on the part of CFTC staff to conduct
comparability assessments, does not give the market
confidence that cross-border reconciliation of the
uncleared margin requirements will be achieved. This is
of immediate concern, especially given the rather short
implementation date for the largest institutions—which
generally have global businesses.
The timeframe for implementation of the final rules
by market participants is tight, especially for VM. Lack
of harmonization across jurisdictions will compound
implementation anxieties, create uncertainty and
increase legal risk.
As with many of the reforms in response to the recent
financial crisis, there are unintended consequences
to the introduction of the uncleared margin rules,
some of which are immediately apparent and some
of which will only become evident as industry begins
its implementation. Unfortunately, these reforms may
be pushed through too quickly without resolving the
interpretational issues and legal uncertainties they
create. 
Bank on Us.
Many of the largest financial institutions in the world turn to Morrison
& Foerster for advice on bank regulatory matters, including privacy, money laundering,
commercial and retail banking, regulatory capital, and financing and M&A opportunities.
For our financial services and financial institutions clients, business right now is anything
but usual. Visit www.mofo.com/resources/regulatory-reform/ for information on our
regulatory reform resources, including our proprietary FrankNDodd™ service.
©2014 Morrison & Foerster LLP, mofo.com
By the Numbers
6
3
Billion
$
Paid in income taxes
by the U.S. banking
industry last year.2
6.6%
94,549
The contribution of the U.S.
financial sector to GDP.3
The number of bank branches in the U.S.1
2Million
5
0
Billion
The number of
individuals employed
by TCH Owner Banks
globally.4
$
The total U.S. banks
paid to shareholders
last year.5
2,500
$
.7
1
0
Trillion
The median amount spent
by banks and finance
organizations per
employee on cybersecurity.
$
The total deposits held at
U.S. commercial banks.6
400
$
72
The median amount spent
by retail and consumer
products businesses per
employee on cybersecurity.7
123Billion
The number of
transactions
processed annually
by U.S. banks.
80Trillion
$
5,757
The value of all
annual transactions
processed annually
by U.S. banks.8
440,000
The number of commercial banks
insured by the FDIC in the U.S.11
The number of ATMs in the U.S., the most of any
country in the world.9
582
Billion
$
1.
2.
3.
4.
5.
6.
7.
2
Billion
.
5
The total
amount
loaned by U.S.
banks to small
businesses.10
TCH analysis. SNL Financial.
Bureau of Economic Analysis. U.S. Department
of Commerce. http://www.bea.gov/iTable/iTable.
cfm?ReqID=51&step=1#reqid=51&step=51&isuri=1&5114=a&5102=5
TCH analysis.
FDIC, Quarterly Banking Profile, 2nd Quarter 2014
http://www.pwc.com/en_US/us/increasing-it-ef-
The number of billpayment transactions
initiated by account
holders through online
banking websites or
mobile bill-payment
applications in the last
reported year.12
8.
9.
fectiveness/publications/assets/2014-us-state-ofcybercrime.pdf
The Federal Reserve 2013 Payments Study. 19
December 2013. http://www.frbservices.org/files/
communications/pdf/research/2013_payments_
study_summary.pdf.
Scuffham, Matt and David Henry, “Banks to be hit
with Microsoft costs for running outdated ATMs,”
Reuters. March 14, 2014. http://www.reuters.com/
article/2014/03/14/us-banks-atms-idUSBRE-
A2D13D20140314
10. U.S. Small Business Administration, Quarterly Lending Bulletin, http://www.sba.gov/sites/default/
files/SBL_2013q4.pdf
11. FDIC, Quarterly Banking Profile, 2nd Quarter 2014
12. The Federal Reserve 2013 Payments Study. 19
December 2013. http://www.frbservices.org/files/
communications/pdf/research/2013_payments_
study_summary.pdf.
Research
Rundown
Research Rundown provides a comprehensive
overview of the most groundbreaking and
noteworthy research on critical banking
and payments issues and seeks to capture
insights from academics, think tanks, and
regulators that may well influence the
design and implementation of the industry’s
regulatory architecture.
74
Funding Costs
Financial Firms Less Risky than Other Industries.
The authors compare size-related funding cost
differentials across industries to determine how size
affects the cost of funding. Using pricing data on credit
default swaps and bonds over the period 2004 to 2013,
the paper finds that credit spreads of financial firms are
no more sensitive to size than those of non-financial
firms. They find evidence that financial firms as a
group, particularly banking firms, have lower average
costs of borrowing compared with similar firms in
other industries. This suggests that financial firms
may be viewed as less risky compared to firms in other
industries. The authors conclude that “too-big-to-fail
subsidies may be overestimated if they do not take into
account the lower borrowing costs of larger firms across
a variety of industries.”
Ahmed, Javed, Christopher Anderson and Rebecca
Zarutskie (2014), “Are Borrowing Costs of Large
Financial Firms Unusual?” mineo, Federal Reserve
Board, Harvard Business School, (September).
Lender of Last Resort
Rethinking the Lender of Last Resort. As part of
a series on the future design of lender of last resort
(LOLR), Paul Tucker discusses criticism central banks
face when they inject liquidity into the financial system.
The author states that central bank criticism is about
the “political economy” and such criticism serves as
an “important challenge to the legitimacy” of central
banks. He discusses the criticisms related to the LOLR
function of central banks and contends that once central
banks are “perceived as having overstepped the mark in
bailing out bust institutions, critics look for overreach
in their more overtly macroeconomic interventions.”
Tucker asserts that this is currently the critique of the
Fed in the U.S. The “most serious accusation” by critics
of central bank aid to insolvent firms, he argues, is that
this support reaches beyond the central bank’s “legal
authority.” He attempts to demonstrate that when
financial firms become “deeply reluctant to turn to the
LOLR,” via the discount window, it leaves the financial
system fragile in “ways that are hard for regulation to
undo.”
Tucker, Paul (2014), “The lender of last resort and
modern central banking: principles and reconstruction,”
BIS Papers, 79, (September).
Anonymous Lending Important in Restoring
Confidence. The authors argue that there is a missing
ingredient in “Bagehot’s Dictum.” Walter Bagehot, a 19th
century British journalist and economist, wrote that
“in times of financial crisis central banks should lend
freely to solvent depository institutions, only against
good collateral and at interest rates that are high enough
to dissuade those borrowers that are not genuinely in
need.” The missing ingredient, according to the authors,
is secrecy – three kinds in particular: (i) central bank
lending, (ii) borrower identity, and (iii) presence of
borrowing from the central bank in the borrower’s
portfolio.
Gorton, Gary and Guillermo Ordoñez (2014), “How
Central Banks End Crises,” PIER Working Paper, 14-025,
(September).
Costs of Regulation
Impact of Liquidity Regulation on Lending to NonFinancial Sector. The authors use the implementation
of the Individual Liquidity Guidance (ILG) regulation
in the UK in 2010 to investigate how banks respond
to tighter liquidity regulation. Under this regulation,
a subset of banks were required to hold a sufficient
stock of high quality liquid assets (HQLA) to cover net
outflows of liabilities under two stress scenarios lasting
either 14 days or 3 months. The authors find that rather
than adjusting the size of their balance sheet to meet
tighter liquidity regulation, banks subject to the ILG
altered the composition of their assets and liabilities.
On the asset side, banks significantly increased the
share of HQLA to total assets, and on the liability side,
ILG banks increased funding from more stable deposits
and decreased their reliance on less stable short-term
75
wholesale and non-UK funding. The authors do not
find evidence that liquidity regulations have a negative
impact on bank lending to the non-financial sector,
either in terms of quantity or price of lending. They
conclude that because the ILG significantly reduced
intra-financial claims without having a measurable
impact on the price or quantity of lending to the
real economy, liquidity regulation could be a useful
macroprudential tool.
Banerjee, Ryan and Hitoshi Mio (2014), “The Impact
of Liquidity Regulation on Banks,” BIS Working Papers,
470, (October).
Using Cost-Benefit Analysis to Determine Capital
Requirements. The author posits that: (i) bank regulators
have used a process that he calls “norming” (i.e.,
choosing capital levels that weed out the worst banks but
leave most banks untouched); (ii) norming is a bad way
to regulate banks, as it produces excessively generous
rules that allow most banks to take excessive risks;
(iii) inadequate capitalization of banks contributed to
the financial crisis of 2007-2008; and (iv) if regulators
had been required to use cost-benefit analysis rather
than norming, they would have issued stricter capital
adequacy rules.
Posner, Eric (2014), “How Do Bank Regulators
Determine Capital Adequacy Requirements?” University
of Chicago Coase-Sandor Institute for Law & Economics
Research Paper, 698, (September).
Imposing Basel III Liquidity Regulations Reduces
Bank Lending. The authors look at the macroeconomic
impact of introducing a minimum liquidity standard for
banks on top of existing capital adequacy requirements.
The authors find that imposing a liquidity requirement
would: (i) lead to a steady-state decrease of about 3%
in the amount of loans made; (ii) an increase in banks’
holdings of securities of at least 6%; (iii) a fall in the
interest rate on securities of a few basis points; and (iv) a
decline in output of about 0.3%.
Covas, Francisco and John Driscoll (2014),
“Bank Liquidity and Capital Regulation in General
76
Equilibrium,” Board of Governors of the Federal Reserve
System, Federal Reserve Board- Division of Monetary
Affairs, (September).
Cross-Border Banking
Cross-Border Banking and Liquidity. The authors
investigate global factors associated with bank capital
flows. They create a model where global banks
interact with local banks and find that local currency
appreciation is associated with higher leverage of the
banking sector, thereby providing a bridge between
exchange rates and financial stability. Given the
preeminent role of the U.S. dollar as the currency used
to denominate debt contracts, the authors shed light
on why dollar appreciation constitutes a tightening of
global financial conditions and why financial crises are
associated with dollar shortages.
Bruno, Valentina and Hyun Song Shin (2014) “Crossborder banking and global liquidity,” BIS Working
Papers, 248, (August).
Regulating Cross-Border Bank Flows Lowers
the Risk of Financial Crisis. Using data on bilateral
cross-border bank flows from 31 sources to 76 recipient
countries over 1995–2012, and combining this
information with new data on various capital controls
and prudential measures in these countries, the authors
examine whether cross-border capital flows can be
regulated by imposing capital account restrictions at
both source and recipient country ends. They find that
capital account restrictions (CARs) can significantly
influence the volume of cross-border bank flows. Given
the close connection between cross-border bank flows
and risks to global financial stability, the authors suggest
that “adoption of relevant CARs in boom times could
help to dampen the procyclicality of these flows, thereby
lowering the risk of systemic financial crises.”
Ghosh, Atish, Mahvash Qureshi and Naotaka Sugawara
(2014), “Regulating Capital Flows at Both Ends; Does it
Work?” IMF Working Paper, 14, 188, (October).
If only there was only a better
way to help manage, control and
sustain your resolution planning.
There is.
No matter how you view resolution planning, you’re looking at
time and effort. And if you miss something, you could end up
facing even more stringent requirements and restrictions. That’s
where KPMG’s Resolution Planning Service and its enabling
technologies come into play. We help you harness the power
of data analytics to collect the information you need, provide
analysis that addresses regulatory requirements, and—in the
end—help you create a sustainable process. Which means
you can spend less time on your compliance efforts and
more time focusing on the other tasks on your list.
Contact Christopher Dias at cjdias@kpmg.com
kpmg.com
Some or all of the services described herein may not be permissible for KPMG audit clients and their affiliates.
© 2014 KPMG LLP, a Delaware limited liability partnership and the U.S. member firm of the KPMG network of independent
member firms affiliated with KPMG International Cooperative (“KPMG International”), a Swiss entity. 140207
Payments
Digital Currencies. The authors discuss recent
developments in payment systems, specifically focusing
on the emergence of privately developed, internetbased digital currencies. The article argues that the
key innovation of digital currencies is found in the
“distributed ledger” technology that allows a payment
system to operate exclusively in a decentralized
fashion, without any intermediaries such as banks. The
authors contend that this key innovation represents a
fundamental change in how payments can be made to
work. The article also provides an overview of how digital
currencies work, as well as how new currency is created.
Ali, Robleh, John Barrdear, Roger Clews and James
Southgate (2014), “Innovations in payment technologies
and the emergence of digital currencies,” Bank of
England Quarterly Bulletin, 2014 Q3.
Non-banks in Retail Payments. CPMI finds a
significant presence of nonbanks in all stages of
the payment process and across different payment
instruments. The study analyzes all activities in the
payment chain, such as credit and debit cards, credit
transfers, direct debits, checks, e-money products
and remittances. The paper finds that while the role
of nonbanks in retail payments is increasing, most
nonbanks ultimately rely on the credit/debit transfer
services provided by banks for their funds settlement.
Ultimately, the paper concludes that competition from
nonbanks is driving banks to offer more efficient or
faster payment services, which suggests that properly
managed cooperation and competition between banks
and nonbanks could enhance the security and efficiency
of retail payments to the benefit of end users.
Committee on Payments and Market Infrastructures
(2014), “Non-banks in retail payments,” Bank for
International Settlements, (September).
Risk Management
Market Risk and Internal Models. The Basel
Committee presents results from the first of two
trading book test portfolio exercises, which focused
on the revised internal models-based approach for
market risk and is based on hypothetical portfolios.
The second exercise focuses on banks’ actual portfolios
and is being conducted in parallel with the Basel III
monitoring exercise. The Basel Committee reports that
the hypothetical portfolio exercise on the internal models
approach provided encouraging results supporting the
new market risk framework. Over 40 banks from various
jurisdictions were able to implement the requirements
for internal models. Banks were able to leverage the
existing risk systems and perform the computation
for the new risk measures within two quarters of the
publication of the consultative document.
Basel Committee on Banking Supervision (2014),
“Analysis of the trading book hypothetical portfolio
exercise,” Bank for International Settlements,
(September).
How Credit Default Risk Affects Bank Lending?
The authors find that: (i) an increase in provisioning
decreases bank lending and economic activity; and (ii)
banks decrease provisioning as a percentage of total bank
assets as bank lending increases. Therefore, banks take
on more risk during upswings by building up relatively
low provisions while they build up more loan loss
provisions during downswings.
Pool, Sebastiaan, Leo de Haan and Jan Jacobs (2014),
“Loan loss provisioning, bank credit and the real
economy,” DNB Working Paper, 445, (October).
Systemic Risk
Structural GARCH Model Provides Earlier Signals
of Financial Firm Distress. The authors propose a new
model of volatility the authors call “Structural GARCH”,
which they then apply to the leverage effect and systemic
risk measurement. While normal GARCH models
78
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do not include the volatility-leverage connection, the
Structural GARCH provides a framework for empirical
modeling of asset volatility, equity volatility, and
leverage. The Structural GARCH model for systemic risk
measurement provides earlier signals of financial firm
distress. Additionally, the authors define a new measure
they call “precautionary capital,” which determines how
much equity firms need to add today in order to ensure
an arbitrary level of confidence that the firm will not go
bankrupt in a future crisis.
Engle, Robert and Emil Siriwardane (2014),
“Structural GARCH: The Volatility-Leverage Connection”
OFR Working Paper, 14-07, (October).
Impact of Systemic Risk on Bank Failure. The authors
find that: (i) the impact from systemic risk on bank
failure appears to be strong over the one-year forecast
horizon but weakens over the one-quarter horizon;
(ii) firms with higher capital ratios are more affected
by systemic risk, suggesting that the buffer provided
by higher capital ratios is weakened during the period
when systemic risk is high; (iii) small banks are equally
affected by systemic risk; and (iv) local housing market
conditions are a major determinant of bank failure.
Wu, Deming and Xinlei Zhao (2014), “Systemic Risk
and Bank Failure,” mimeo, Office of the Comptroller of
the Currency, (August).
Interchange Fees
Interchange Fee Income Significantly Reduced for
Banks. The authors find that Regulation II reduced
income at large banks by nearly $14 billion a year
or more than 5% of core total noninterest income.
Furthermore, in response to the decreased revenue for
card transactions banks increased their deposit fees
which offset roughly 30% of the lost interchange income.
Kay, Benjamin Mark Manuszak and Cindy Vojtech
(2014), “Bank Profitability and Debit Card Interchange
Regulation: Bank Responses to the Durbin Amendment,”
Finance and Economics Discussion Series, Divisions
80
of Research & Statistics and Monetary Affairs, Federal
Reserve Board.
Bank Structure
Ring Fencing Foreign Affiliate Increases Stress
on Parent Bank. The authors find a significant
positive correlation between parent banks’ and their
foreign subsidiaries’ default risk. This risk is lower
for subsidiaries operating in countries that impose
higher capital, reserve, provisioning, and disclosure
requirements and tougher restrictions on bank activities.
The authors note that although tighter host banking
regulations seem to help insulate foreign subsidiaries
from changes in the default risk of parent banks during
crises, ring fencing measures taken by authorities in one
country could increase stress on the banking group’s
legal entities in other jurisdictions or for the banking
group as a whole. Furthermore, ring fencing may create
inefficiencies in the allocation of capital and liquidity
within multinational bank groups.
Anginer, Deniz, Eugenio Cerutti and Maria Soledad
Martinez Peria (2014), “Foreign Bank Subsidiaries’
Default Risk During the Global Crisis,” World Bank,
Policy Research Working Paper, 7053, (October).
Capital
Leverage Based Capital Constraint Superior When
Monitoring Loan Portfolios. The paper investigates
whether a bank faced with a leverage based capital
constraint monitors its loans better than a bank under
a risk-based capital constraint. It finds that the biggest
banks will monitor their portfolios when faced with
leverage-based capital constraints, and will not monitor
their portfolios when faced with risk-based capital
constraints. According to the report, it appears that
leverage ratios have better pre-crisis predictability than
risk based approaches.
Balasubramanyan, Lakshmi (2014), “Differential
Capital Requirements: Leverage Ratio versus Risk-Based
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Capital Ratio from a Monitoring Perspective,” Federal
Reserve Bank of Cleveland Working Paper, 14-15,
(October).
More Capital Would Improve Resilience. The authors
use data on UK banks’ minimum capital requirements to
study the interaction of monetary policy and regulatoryimposed capital requirements. They find that capital
requirements are a more powerful tool for achieving
financial stability objectives related to loan supply than
monetary policy and therefore argue that “minimum
capital requirement changes might offer a more potent
tool for improving the resilience of the financial system,
by moderating bank lending, over the cycle.”
Aiyar, Shhekhar, Charles Calomiris and Tomasz
Wieladek (2014), “How does credit supply respond
to monetary policy and bank minimum capital
requirements?” Bank of England Working Paper, 508,
(September).
Stress Testing
What Governs Recovery from Banking Crises? The
authors find that banks that are tougher on extending
credit to their riskiest customers tend to recover from
sudden declines in profitability. Based on this finding,
the authors propose that regulators adjust bank stress
tests to keep track of which customers’ loans would
go bad during a crisis, and to consider how readily a
bank can manage these problems. They conclude that
indiscriminant reductions in lending seem to be less
important than managing the risk associated with the
riskiest borrowers.
Kashyap, Anil and Emilia Bonaccorsi di Patti (2014),
“Which Banks Recover from Large Adverse Shocks?”
Chicago Booth Research Paper, 14-34, (September).
Bank Balance Sheets
Non-Traditional Bank Income Is Associated with
Higher Bank Profitability. The authors examine how
82
banks’ non-traditional activities affect profitability and
risk taking. Using data from bank Call Reports, they
examine whether a higher ratio of non-interest income
(i.e., bank’s non-core activities) to interest income (i.e.,
bank’s core deposit-taking and lending activities) is
linked to higher bank profitability and risk taking. The
authors find that a higher fraction of non-interest to
interest income is associated with higher profitability,
and that the higher profitability does not result from
higher risk taking. Furthermore, the they find that banks
which generate a higher fraction of their income from
non-traditional business have a lower probability of bank
insolvency.
Saunders, Anthony, Markus Schmid and Ingo Walter
(2014), “Non-Interest Income and Bank Performance:
Is Banks’ Increased Reliance on Non-Interest Income
Bade?” mimeo, New York University, University of St.
Gallen, (October).
CCPs
Assessing the ‘Cover 2’ Standard for CCP Regulation.
The authors address the safety and soundness of CCPs,
specifically looking at the regulatory standard for CCPs,
called ‘cover 2’, which states that systemically important
clearing houses must have sufficient financial resources
to ‘cover’, or be robust under the failure of, their two
largest members in extreme circumstances. They argue
that this is an unusual standard because it does not
take into account the number of members a CCP has
and question the prudency of the ‘cover 2’ standard
for different sizes of CCP. The authors determine that
CCPs meeting the ‘cover 2’ standard are not highly risky
assuming that tail risks are not distributed uniformly
amongst CCP members. However, the findings support
the conclusion that CCPs and their supervisors should
monitor this distribution as central clearing evolves.
Murphy, David and Paul Nahai-Williamson (2014),
“Dear Prudence, won’t you come out to play? Approaches
to the analysis of central counterparty default fund
adequacy,” Bank of England, Financial Stability Paper, 30,
(October). 
I expec¶ my bank §o:
Know my business,
not just my balance.
Some business owners expect more than just an account.
They expect their bank to understand their business.
When it’s time, come to Comerica. And discover why we’re
the leading bank for business,* with more awards
for excellence** than any other bank.
RAISE YOUR EXPECTATIONS.
®
Business
Wealth Management
Personal
comerica.com
MEMBER FDIC. EQUAL OPPORTUNITY LENDER.
*Based on commercial and industrial loans as a percentage of total assets. Data provided by Thomson Reuters Bank Insight, June 2014. **Greenwich Associates is a leading worldwide strategic consulting and research firm specializing in financial services. For Middle Market,
the Greenwich Awards are based on nearly 14,000 market research interviews with U.S. companies with sales revenues of $10 million-$500 million, and honorees were recognized by their customers as providing superior quality of products, service and coverage. Of more than
750 U.S. banks evaluated, Comerica ranked within the top 5 percent of banks with “distinctive quality” and “performing at a differentiated level relative to peers.” For Small Business, the Greenwich Awards are based on more than 17,000 market research interviews with U.S.
companies with annual revenues of $1 million-$10 million, and honorees were recognized by their customers as providing superior quality of products, service and coverage. Of more than 750 U.S. banks evaluated, Comerica ranked within the top 6 percent of small business
banks with “distinctive quality” and “performing at a differentiated level relative to peers.”
CBP-4177 10/14
Featured Moments
TCH Annual Fall Leadership Dinner. The Clearing House held its Annual Fall Leadership Dinner in September at the St. Regis Hotel
in Washington, D.C. to honor the contributions and efforts of all TCH Owner Banks.
The University of Chicago’s Randy Kroszner delivered keynote remarks on monetary
policy and macroprudential regulation.
Union Bank’s CEO, Masashi Oka, greets Bank of
America’s Brian Moynihan at a reception before the
dinner.
JPMorgan Chase’s Stephen Cutler and KeyCorp’s Paul Harris.
84
BB&T’s Kelly King and the Financial Services Forum’s Rob Nichols.
Sullivan & Cromwell’s H. Rodgin Cohen, the Brookings Institution’s Doug Elliott,
and Comerica’s Ralph Babb pose for a photo at the pre-dinner reception.
Fifth Third Bank’s Kevin Kabat enjoys a conversation
at the pre-dinner reception.
U.S. Bank’s Richard Davis introduces the University
of Chicago’s Randy Kroszner before his keynote
remarks.
JPMorgan Chase’s Sandra O’Connor, Paul Saltzman of The Clearing House, and
Pat Parkinson and Barbara Rehm of Promontory on the St. Regis patio.
85
In the Vault
Ceremonial Trowel
This ceremonial trowel was used to lay the
cornerstone of TCH’s Cedar Street building in 1894.
TCH’s home until 1963, the Cedar Street building
contained a collection of now rare coins minted in
1896 – the year of the building’s dedication.
86
© 2014 Citigroup Inc. Citi and Citi with Arc Design are registered service marks of Citigroup Inc.
THE
WORLD’S
CITI. IT’S
WHEREVER
YOU ARE.
It isn’t New York or London
or Beijing. It’s not Lagos or
São Paulo or Dubai. Today,
it’s wherever you are.
Where you bring your ideas,
drive, passion and a hope
that someone will believe
in you. What if a bank made
that its job? Where people
come together to create
or build something, we’re
there to help make it real.
For over 200 years.
Around the world.
citi.com/progress
Celebrating more than 160 years
of leadership, collaboration
and innovation.
For more than 160 years, The Clearing House and
its Owner Banks have together addressed the most
critical issues facing the banking industry and created
innovative solutions to common problems. And our
accomplishments are many—from helping shape
banking policy and regulation to the creation and
operation of safe and sound payment systems.
The legacy of working together is a framework that
will provide the banking industry with great new
possibilities and success in the future.
Bank of America
Bank of the West
Barclays
BB&T
BNY Mellon
Capital One
Citi
Citizens
Comerica
Deutsche Bank
Fifth Third
HSBC
JPMorgan Chase
KeyBank
M&T
PNC
Santander
State Street
SunTrust
TD Bank
UBS
Union Bank
U.S. Bank
Wells Fargo

the full issue

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