Unshackle the banks to prevent a deeper recession

by DANIEL BABICH/ pic by BLOOMBERG

UNLIKE in 2008, when the banking sector brought about the financial crisis, today it can help keep the economy from suffering a deep recession — but only if reforms enacted by regulators in the last decade are relaxed.

Central banks around the world have quickly sprung to action cutting interest rates and reactivating various financial crisis era programmes. Although these steps are necessary, they rely on the banking system to transmit easier financial conditions into credit for the economy.

The issue is that several reforms enacted after the financial crisis will limit the banking system from optimally responding to central banks’ actions. In short, any rule or regulation that restrains efforts by the banking system to promote growth should be suspended until the current crisis subsides. The post-crisis financial reforms introduced stringent capital and liquidity requirements that have transformed banking systems in the US and elsewhere in an effort to make them safer and better able withstand downturns.

The new liquidity requirements limit funding mismatches to ward off bank runs, and regulatory capital has been materially improved in both quantity and quality.

On March 15, the US Federal Reserve (Fed) urged banks to use their excess liquidity and capital in order to support borrowers and ultimately the economy. However, the corresponding liquidity and capital requirements weren’t formally waived.

These requirements should be suspended or adjusted lower, or they will constrain banks as the crisis persists.

The reforms also introduced leverage requirements that restrict the overall size of bank balance sheets regardless of the mixture and risk profile of assets.

This ratio basically functions as a backstop to prevent banks from accumulating seemingly low risk assets to boost returns and becoming excessively leveraged.

But broker-dealers and investment banks have traditionally functioned as principles and provided liquidity during times of volatility, like in recent weeks, by warehousing financial securities.

A leverage limit strongly inhibits this flexibility and effectively curbs their ability to act counter-cyclically during times of financial panic.

Following from lessons learned during the last financial crisis, accounting and banking regulators introduced a new accounting framework for loan losses, known as the current expected credit loss (CECL) methodology, which changes loan provisioning from an incurred basis to an anticipatory, forward-looking basis.

Although CECL is being implemented by US banks, there is a phase-in period for higher provisions related to existing loan portfolios from the end of 2019. All loans will be dynamically, and procyclically, provisioned starting this year. These provisions are determined by models such that expected losses on both new loans and existing, performing loans will increase as economic forecasts deteriorate.

Banks require capital to extend new loans, so the risk with CECL is simply that bank capital will end up funding provisions on performing, seasoned loans to solid borrowers, which will consequently reduce the capital available to make new loans.

While these reforms were appropriate in the aftermath of the financial crisis, the economic and financial challenges facing the nation now are very different and require decisive changes.

Both the Fed and banking sector have materially changed; those old safeguards, like the gold standard, have been effectively replaced by capital and liquidity requirements for the banking sector.

The Trump administration, Congress and the Fed must show the same flexibility and foresight today and work to eliminate rules and regulations that hinder banks from supporting our economy. — Bloomberg


This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.