August 04, 2017

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

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