Johnson and Klemmer | The Federal Reserve’s other problem

US financial regulators are proposing to significantly reduce capital requirements for global systemically important banks (GSIBs) by weakening the enhanced supplementary leverage ratio (eSLR) from current levels to an average of 3.84%. This move is critically viewed by experts, including Nobel laureate Simon Johnson, as a dangerous step that would increase systemic risk by allowing major banks to operate with substantially less equity, potentially undermining financial stability given historical failures in risk assessment. The article argues that this proposal should be withdrawn due to its failure to adequately address the substantial additional risk it poses to the US financial system.

Analysis

The Federal Reserve, FDIC, and OCC are proposing to significantly weaken the enhanced supplementary leverage ratio (eSLR) for Global Systemically Important Banks (GSIBs) and their insured depository institution subsidiaries (IDIs). This proposal would reduce the required equity from current levels (5.0% for GSIBs, 6.0% for IDIs) to an average of 3.84% for both, as part of a broader deregulatory push.

Experts, including the CFA Institute Systemic Risk Council and Nobel laureate Simon Johnson, strongly oppose this reduction, labeling it a dangerous move that increases systemic risk. They argue that lower equity requirements enhance bank leverage, making institutions more vulnerable to failure and potentially imposing significant costs on the financial system. Historical crises, like the 2008 GFC, underscore the dangers of misjudged risk assessments.

The article highlights that GSIBs' balance sheets grew by 50% from 2015-2024 (US$10.5T to US$15.5T), while risk-weighted assets increased by less than 10% (US$6.09T to US$6.9T), indicating banks optimize asset mixes to reduce capital. This suggests risk-based capital requirements are insufficient, making the simple eSLR crucial. The current proposal is criticized for failing to quantify potential consequences, leading to calls for its withdrawal and a more comprehensive framework discussion.

Key Decisions for Investors

• Investors should closely monitor the progression of the proposed eSLR changes, as a reduction in capital requirements for GSIBs could significantly alter the risk profile of major financial institutions.
• Evaluate the balance sheets of GSIBs for increased leverage and potential asset optimization strategies aimed at boosting return on equity, which may not fully reflect underlying risks.
• Consider potential systemic risks to the broader financial market if these regulations are enacted, particularly the implications for financial stability and the potential for future government interventions or market volatility.