IMF Working Paper on the Nature of Regulatory Capital Requirements
IMF published a working paper that compares the regulatory capital requirements under the Dodd-Frank Act and the 10% leverage ratio, as proposed by the U.S. Treasury and the U.S. House of Representatives' Financial CHOICE Act (FCA). The paper also highlights the potential for regulatory arbitrage by banks and the associated moral hazard problem that arises due to the option of the FCA qualifying banking organizations.
The paper undertakes certain exercises to assess the qualifying banks option. It uses balance sheet data on the types of banks (by asset size) that would qualify for the off-ramp under the FCA and estimates how much capital banks would need to add to qualify for the “off-ramp” regulation. Then, to surmise whether there could be a self-selection of more risk-prone banks in the off-ramp, the paper analyzes the balance sheet characteristics of banks with a relatively small capital gap to the 10% leverage ratio. The analysis identifies an important moral hazard problem that arises due to the qualifying banks' optionality, where banks are likely to increase the riskiness of their asset portfolio and qualify for the FCA “off-ramp” relief, with unintended effects on financial stability. This moral hazard problem would manifest through banks increasing the RWA imprint in their balance sheet through increased risk taking, thereby qualifying for the “off-ramp” regulatory relief, under which banks hold 10% leverage ratio while enjoying higher expected returns and lower regulatory costs. This would make the banks riskier and, due to smaller capital buffers, less resilient to adverse shocks.
However, the results show that small banks (total assets below USD 3 billion) with capital gaps to the qualifying banks threshold would tend not to opt for the “off-ramp.” Despite the stated intention of policymakers to provide regulatory relief for small banks under the proposed FCA, this paper concludes that these banks would opt to stay under the existing Dodd-Frank Act regime. Investors and the market would expect large and globally active banks to meet modern regulatory standards. Also, banks that can have large maturity mismatches and a fewer share of highly liquid assets than demanded under the Dodd-Frank Act or Basel III would be less attractive as a counterpart in the interbank market. Finally, it is also clear that reliance on regulation alone (Pillar 1) cannot be sufficient. Supervisors (Pillar 2) need to continue to increase market discipline (Pillar 3) and transparency, and help financial institutions increase internal risk management capacity and capital planning.
Related Link: Working Paper (PDF)
Keywords: Americas, United States of America, Banking, Dodd Frank Act, Basel III, Capital Requirements, Regulatory Arbitrage, IMF
Featured Experts
María Cañamero
Skilled market researcher; growth strategist; successful go-to-market campaign developer
Nicolas Degruson
Works with financial institutions, regulatory experts, business analysts, product managers, and software engineers to drive regulatory solutions across the globe.
Patrycja Oleksza
Applies proficiency and knowledge to regulatory capital and reporting analysis and coordinates business and product strategies in the banking technology area
Previous Article
IASB Issues Amendments to IFRS 9 and IAS 28Related Articles
BIS and Central Banks Experiment with GenAI to Assess Climate Risks
A recent report from the Bank for International Settlements (BIS) Innovation Hub details Project Gaia, a collaboration between the BIS Innovation Hub Eurosystem Center and certain central banks in Europe
Nearly 25% G-SIBs Commit to Adopting TNFD Nature-Related Disclosures
Nature-related risks are increasing in severity and frequency, affecting businesses, capital providers, financial systems, and economies.
Singapore to Mandate Climate Disclosures from FY2025
Singapore recently took a significant step toward turning climate ambition into action, with the introduction of mandatory climate-related disclosures for listed and large non-listed companies
SEC Finalizes Climate-Related Disclosures Rule
The U.S. Securities and Exchange Commission (SEC) has finalized the long-awaited rule that mandates climate-related disclosures for domestic and foreign publicly listed companies in the U.S.
EBA Proposes Standards Related to Standardized Credit Risk Approach
The European Banking Authority (EBA) has been taking significant steps toward implementing the Basel III framework and strengthening the regulatory framework for credit institutions in the EU
US Regulators Release Stress Test Scenarios for Banks
The U.S. regulators recently released baseline and severely adverse scenarios, along with other details, for stress testing the banks in 2024. The relevant U.S. banking regulators are the Federal Reserve Bank (FED), the Federal Deposit Insurance Corporation (FDIC), and the Office of the Comptroller of the Currency (OCC).
Asian Governments Aim for Interoperability in AI Governance Frameworks
The regulatory landscape for artificial intelligence (AI), including the generative kind, is evolving rapidly, with governments and regulators aiming to address the challenges and opportunities presented by this transformative technology.
EBA Proposes Operational Risk Standards Under Final Basel III Package
The European Union (EU) has been working on the final elements of Basel III standards, with endorsement of the Banking Package and the publication of the European Banking Authority (EBA) roadmap on Basel III implementation in December 2023.
EFRAG Proposes XBRL Taxonomy and Standard for Listed SMEs Under ESRS
The European Financial Reporting Advisory Group (EFRAG), which plays a crucial role in shaping corporate reporting standards in European Union (EU), is seeking comments, until May 21, 2024, on the Exposure Draft ESRS for listed SMEs.
ECB to Expand Climate Change Work in 2024-2025
Banking regulators worldwide are increasingly focusing on addressing, monitoring, and supervising the institutions' exposure to climate and environmental risks.