The Collins flaw: backstop turned binding constraint

In the final quarter of last year, every one of the eight largest US banks hit the so-called Collins floor. Analysis shows this has not happened for six years, possibly longer.

This raises questions over the growing divergence between regulators’ methods for calculating risk-weighted assets, and banks’ own models. It’s a worry for both banks and regulators.

The Collins floor refers to a 2010 amendment to the Dodd-Frank Act sponsored by Republican senator Susan Collins. The amendment requires large US banks to calculate their capital adequacy using regulators’ standardised approaches as well as their own internal models, and to apply the tougher of the two outputs.

The main difference between the two methodologies is that the standardised approach excludes capital requirements for operational risk, credit valuation adjustments and, in part, low-default loans. This was the outcome of long negotiations between regulators in the post-crisis world to provide dealers with some guardrails while leaving them enough wiggle room to assess their own risk-based capital.

Since then, US banks have sporadically hovered around the Collins floor. Some, like Wells Fargo, ducked under and have never re-emerged. Others, like Citi and Morgan Stanley, have crossed it in both directions several times.

And in the last quarter of 2021, Goldman Sachs was the latest bank to join the club, following the adoption of the new standardised approach to counterparty credit risk.

The gap between standardised and internal risk-weighted assets now varies significantly across the eight systemically important banks, even though they are all constrained by the same methodology. Take Bank of America, for example, which reported the biggest divergence between the two measures at the end of last year, at $219 billion, and compare it to State Street, which had the smallest gap, at just $658 million.

Does the issue lie within the existing standardised approach, and a rethink is therefore needed, or are banks’ internal models simply no longer accounting for the extent of their credit and market risk?

It’s not immediately clear why this is, and upcoming articles will try to shine a light on it.

Meanwhile, this new unique environment raises a number of questions for all parties involved.

First, how come all the dealers are now below the floor? Granted, unlike the standardised approach, the advanced method takes into account op risk, which has been shrinking across the board since 2008 and played a role in lowering total risk-weighted assets. However, the op risk decline is simply not enough to justify the overall downward move, meaning the way credit and market risk are being assessed under the two methodologies is diverging more significantly than it did in the past.

The question is whether this is happening because regulators’ own risk calculations have become out of sync with banks’ own methodologies. And if that’s the case, does the issue lie within the existing standardised approach, and a rethink is therefore needed, or are banks’ internal models simply no longer accounting for the extent of their credit and market risk?

Second, banks’ capital managers will likely debate whether it’s worth pursuing a strategy aimed at constantly refining their models – something that costs time and resources – when there is no regulatory capital benefit to be gained. You don’t get owt for nowt, and that’s even more true when it comes to banking.

But perhaps most important are the questions for policy-makers. What was once intended as backstop capital safeguard is now a binding constraint for all systemic banks. Does it make sense to keep a rule in place that encourages dealers to adopt their internal models to set capital requirements, and yet strips away any capital gains from doing so past a certain threshold?

It’s unclear whether Senator Collins anticipated this moral hazard, but she and other lawmakers may soon be forced to consider an amendment to her amendment.