Fed officials are concerned that parts of a key tool that regulators
have developed to measure banks' riskiness—known as "Basel III
capital rules" -- are flawed and can be gamed by the companies.
Under Basel, banks can determine how much debt they can take on by
using their own models and computer systems to calculate how risky
their assets are, among other methods. The higher the risk, the less
money banks can borrow and lend, in turn cutting income banks can
earn. In other words, the Basel rules give banks a chance to monkey
with their risk models to boost profit.
In a May speech, Fed Governor Daniel Tarullo condemned the latitude
that Basel III gives banks to use their own models. While he was
expressing his own views, a source familiar with the matter told
Reuters that Tarullo's opinion is held by other governors.
Instead of the Basel rules, Tarullo promoted the use of the Fed's
own yardstick of bank health, a test of how bank assets would
perform during market turmoil or an economic slump. That process,
which the Fed has developed separately from the Basel regulations,
is known as the "stress test."
"As a practical matter, it is our binding capital standard," said
John Dugan, former U.S. Comptroller of the Currency and now a
partner at the law firm of Covington & Burling in Washington.
The Fed's decision to emphasize a different process for evaluating
risk is maddening to banks, who complain that the Fed's tests are
opaque. The regulator fears that banks would find ways to cheat the
tests if they knew too much about the methodology, so it gives them
little detail about it. Every year, the Fed can also change the
stressful situations it tests for.
Wall Street says it's getting mixed signals about Basel III from the
Fed. Tarullo's remarks come less than three months after U.S.
regulators gave the green light to eight big U.S. banks to use their
own risk models.
One senior bank executive who refused to be named complained that
the regulator wants "a private playbook" which it can redesign every
year. Another called the stress test process "arbitrary and scary."
The world's biggest banks have probably spent billions of dollars in
recent years building computer models, hiring staff and selling
assets to comply with Basel III, analysts said. An executive at a
major bank told Reuters last year that his firm had spent $500
million on models and systems alone.
Without more detail about the Fed's rules, banks must hold more
capital, possibly constraining their lending and global growth,
bankers said. Wells Fargo & Co, the fourth-largest U.S. bank, said
at a recent conference that it is holding more capital in large part
because of the Fed's stress test.
Many regulators have little patience with these complaints. In the
run-up to the financial crisis, banks succumbed to the temptation to
boost earnings by borrowing more money to fund their assets. If a
bank has too much debt, even slight declines in the value of its
assets can put it out of business, a lesson that Lehman Brothers
Holdings Inc learned the hard way.
The Fed and other regulators are charged with maintaining the health
of the financial system, not maximizing bank profits.
Regulators may have reason to be alarmed about the way banks are
measuring asset risk. Last year, the Basel Committee, which is
refining the current generation of Basel rules, said it found wide
variance in how banks assessed the riskiness of hypothetical
portfolios of loans and trading assets. A Barclays Capital survey in
2012 found that half of investors distrust banks' assessments of the
riskiness of their assets.
Banks rarely confess to changing their risk models to reduce their
capital requirements, but evidence of its happening came to light
last year, when a U.S. Senate subcommittee released e-mails in which
JPMorgan Chase & Co executives discussed how they were changing
their models to reduce the apparent riskiness of their assets.
Policing banks' models is labor intensive, and regulators are
finding their staff and resources stretched. Even the head of the
Basel Committee acknowledged in March that adjusting assets for risk
poses difficulties for regulators.
"The message I would like to leave you with today is that there is
one (a problem), and we plan to do something about it," said Basel
Committee Chairman Stefan Ingves in a speech in New York.
The Federal Reserve is not inclined to wait to fix rules that global
regulators have been discussing and refining for a decade. The
central bank has added its own rules to a separate part of the Basel
capital requirements, known as the leverage ratios, which do not
consider the riskiness of assets.
Tarullo's harsh criticism of the Basel risk measures came in a May 8
Referring to bank models for calculating asset risk, called the
"internal-ratings-based approach," he said, the "combined complexity
and opacity of risk weights generated by each banking organization
for purposes of its regulatory capital requirement create manifold
risks of gaming, mistake, and monitoring difficulty."
[to top of second column]
Later, he said, "in light of all that has happened in the last
decade, I see little reason to maintain the requirements of the IRB
approach for our largest banks."
Fed staffers interviewed by Reuters said Tarullo's tone and timing
were surprising, given the amount of energy that both U.S.
regulators and the banks have put into adopting the third generation
of Basel rules, which must be fully implemented by the beginning of
"They've invested so much time and effort into that process, and
it's an international agreed-upon standard, so to say to scrap it –
it's a pretty bold statement," said an employee at a regional
Federal Reserve bank who did not want to be identified.
Federal Reserve spokeswoman Barbara Hagenbaugh declined to comment.
Regulators have been working on the third set of Basel rules for a
decade, but the effort gained extra momentum after the financial
crisis, when investors and depositors feared that banks had too much
debt and too little equity, or capital, funding their assets.
Capital represents a cushion that banks have against their assets
losing value during times of stress—maintaining enough of a buffer
is critical to preventing runs on banks during crises. When
investors and depositors lost faith in banks, governments and
central banks globally had to pump trillions of dollars into the
financial system to bail out lenders.
The Fed developed the stress tests in 2009 in part to restore trust
in the financial system. Investors unsure about bank-asset values
took comfort that regulators were checking that banks would be
solvent during a crisis.
These tests, combined with the Fed's decisions about whether banks
can afford to buy back more shares and increase their dividends,
have become increasingly important to the regulator, sources said.
The European Central Bank, which will become the continent's bank
supervisor before the end of the year, is also developing its own
stress tests known as the asset quality review.
Banks including Citigroup Inc and Bank of America Corp have been
embarrassed to have had capital plans rejected by the Fed. Their
failures have encouraged others to be more cautious managing their
capital, analysts said.
John McDonald of Bernstein Research in New York recently estimated
that changes in the Fed's grading methods this year canceled out
some $60 billion of excess capital at three big banks, Citigroup,
Bank of America and JPMorgan Chase & Co.
Changing complexities of the Fed's testing "could have negative
implications for the way banks are run," according to McDonald.
Three senior Wall Street executives complained to Reuters about the
Fed's shifts towards its own tests, though none would be named for
fear of insulting their regulator.
A former Fed staffer who now works in the industry said Tarullo is
wrong to be so confident in the Fed's own models, which have been
changing year-to-year and haven't been tested in another crisis. In
the most recent round of stress tests, the Fed discovered flaws in
its models that it said were minor.
It had to adjust its calculations and release revised numbers the
next day. Even if one bank's model is not the best, the person said,
models from the top 150 banks in aggregate are likely better than a
single model from one regulator.
A consequence of banks not knowing how the models will work, the
person said, is that banks will be more reluctant to take chances
lending and investing. "You are really tamping down potential growth
in the economy," the person said.
(Reporting by David Henry in New York and Emily Stephenson, Michael
Flaherty and Douwe Miedema in Washington. Additional reporting by
Peter Rudegeair in New York. Editing by Dan Wilchins and John
[© 2014 Thomson Reuters. All rights
Copyright 2014 Reuters. All rights reserved. This material may not be published,
broadcast, rewritten or redistributed.