In the wake of the 2008 financial crisis banks that are deemed to be systemically important financial institutions (“SIFIs”) are required to undergo periodic stress tests. The comprehensive capital analysis and review (“CCAR”) stress tests are designed to see how large shocks to the economy would damage these large bank-holding company balance sheets. The 2014 CCAR tests had very mixed results on the 30 banks that took part in the test, with Citigroup having their capital plan rejected and others banks facing capital shortfalls.
While most met the capital targets under the very severe economic conditions proposed in the stress tests, there has also been a new push to raise capital at major US financial institutions:
Under the rule, banks with over $700 billion in assets will have to raise their capital, measured by the leverage ratio, to 5 percent of their overall assets. The ratio will have to be 6 percent at the banks’ federally insured banking subsidiaries, where many of their riskiest activities are.
Raising capital is costly however, and many in the financial services industry are opposed to the idea first put forth in the Basel III agreement in 2011. This is all complicated by moral hazard and the too-big-to-fail problem. So, there is an apparent trade-off between freedom for an institution to do what it wants and the regulation that authorities see fit to put in place to protect the integrity of the system itself. In all likelihood there is not one correct level or way to calculate capital requirements or regulation. Therefore, it seems that this debate will never end.
Questions you might answer:
- How should regulators or banks determine the proper amount of capital or leverage? Should regulators set these guidelines or should they be left up to the private market?
- How does “too big to fail” enter into this problem? When banks are deemed TBTF they likely expect to be bailed out even if they do not have the capital to remain solvent. This is a moral hazard argument that begs the question if we can actually end “too big to fail” as suggested by President Obama after passing the Dodd-Frank Act.
- What about the European banks in these tests? Why aren’t they being tested by their own authorities? Are they tested by the ECB? What right or responsibility do we have to regulate these firms?