Powell Signals Fed May Ease Basel III and Leverage Rules, Sparking Debate on Bank Risk

Federal Reserve Chair Jerome Powell said the central bank was reassessing two significant capital rules: Basel III and the leverage ratio.

Powell’s statement during a briefing to legislators recently was short on specifics, but his tone suggests that the Fed may ease some of the rules that limit how much risk can be held on bank balance sheets. The adjustment could put more lenient lending regulations back on the table.

The Fed, Powell explained in his Senate hearing, is thinking about “essentially two big pieces now: Basel III and the leverage ratio,” and he expects rapid decisions on both.

Lobbying groups, including the American Bankers Association and Bank Policy Institute, have complained about Basel III rules under consideration that overstate risk and make banking’s job of lending more difficult — even on riskier loans.

Reform on capital requirements has the backing on Capitol Hill among Republicans and from the financial world. They argue that U.S. banks face an uphill fight because standards for capital are stiffer than international standards.

The new Basel III proposal features an “output floor” which limits how much banks can lower their required capital via internal models. Critics say it hampers lending and cripples balance sheet management for banks.

Powell seemed to agree. He explained that all assets are treated equally under the leverage ratio, including an asset that is riskier than another.

“If leverage ratio is not risk sensitive, it regards every asset as equally risky,” Powell stated. That hampers banks’ incentives to deal with risks, and actually deters banks from undertaking relatively low-risk activity.

Rules on capital keep banks from suffering losses, but how rules are designed is important. Risk-based rules link capital to the types of assets held by banks. The leverage ratio imposes an across-the-board rule on all assets, regardless of how risky or cautious they are.

If the Fed relaxes the rule on leverage, there is the possibility that banks will be given increased latitude to operate, particularly on the safe side such as on home loans or credit for small businesses.

In theory, that would add access to safe credit and help the economy. It could also bring some unintended risks. If banks are wrong about risk, or market controls don’t work, lower capital reserves may be riskier.

Large banks would be pushed to seek higher returns from riskier behavior — especially while the markets themselves are volatile. Smaller or middle-sized institutions would also be hurt from competing on an uneven terrain where only the titans benefit from loosened rules.

The divide in Congress was clear-cut. Massachusetts Sen. Elizabeth Warren warned against unwinding regulations at the Fed for fear of another crash.

“These short-sighted changes will increase the likelihood that these megabanks once again tank the economy and come here, begging Congress for bailouts when their risky bets go bust,” she wrote.

Republicans said new rules would bring U.S. banks on par internationally. Republicans agreed with Powell that risk-based rules for capital are a more prudent method for regulating safety. Powell claimed that the Fed is still committed to making the system safe even when it reviews its current rules.

Powell offered no deadline, but there are indications he will be acting soon. Sources indicate Fed officials huddled behind closed doors after the hearing to discuss changes to the leverage ratio. Changes to Basel III are possible later this year.

That would have an important impact for banks. Fewer capital constraints would potentially allow for more lending, higher profit, and more freedom to handle money.

Democrats and Republicans are divided on the capital rule suggestion. Democrats warn about risk while Republicans push for fewer regulations.

Some investors and regulators are afraid new risks are engendered when safeguards are eliminate. Megabank shares increased following comments from Powell — which shows there is an upside perspective but still some concern.

Deviating from international Basel III standards would also be problematic for multinational banks as it would be harder to coordinate with international regulators.

Powell also rejected a separate proposal from Senator Ted Cruz that would have kept the Fed from paying interest on bank reserves. That proposal is unpopular to start with, but the exchange illustrates how intimately entangled monetary and regulatory policy are.

Bottom line: It isn’t about banking math but about who will control the rules and how much discretion there will be. We’ll see soon enough whether the Fed goes for flexibility or plays it safe.

As Powell and his officials weigh rewriting rules, banks, markets, and Congress will need to weigh the benefits and costs of relaxing constraints on banks taking risks.