Surcharge of the light-touch brigade

Of all the instruments of the post-crisis regulatory regime, the US global systemically important bank (G-Sib) surcharge was one of the easiest targets for deregulatory reform. The original rule stipulated that the coefficients used to scale G-Sib scores should be updated periodically to reflect the natural growth of systemic indicators over time. In 10 years since the rule’s adoption, this had not happened once.

This was a key justification used by advocates of reform, who pointed out that, whereas G-Sib scores for banks outside the US were adjusted every year in line with changes to the banking system, in the US they were still benchmarked against figures that were more than a decade old. Existing coefficients are based on global aggregate systemic risk indicators from 2012-13 and exchange rates from 2011-13.

Even the most diehard of Dodd-Frank defenders could scarcely object to an update of the coefficients in line with the existing methodology – and a tweak to enable them to be updated automatically in the future – but that’s not what happened. 

Instead, the final reform applies a uniform one-sixth reduction in coefficients across the board, unrelated to the measures of global systemic risk and exchange rates that were factored into the original methodology.

The Federal Reserve’s proposal for the G-Sib surcharge will be much more deregulatory in future than it is in the immediate term

The Federal Reserve included the simple update option as a reasonable alternative, allowing us to compare it to the actual proposal. According to the Fed’s projections, G-Sib scores under the proposal would decline by 22% on aggregate, whereas updating the coefficients under the existing regime would have reduced scores by only 17.4%. Translated into impact on surcharge capital, the disparity was starker: a 10% reduction for the proposal versus 2.4% for a simple update.

The reform takes an even more deregulatory tack when focusing on the proposed adjustments for the future.

Going forward, coefficients are to be reduced to account for economic growth, as measured in GDP. To give an idea of potential future impact, if this method had been used to update coefficients based on growth since 2015, they would have dropped 39.4% by 2025. This would translate into lowering G-Sib scores from the systemic indicators alone by 1,433 basis points – more than double their actual reduction of 606bp.

To put this reduction into context, we can compare it to all the options the Federal Reserve put on the table. In addition to the proposal itself and the simple update (alternative 2), these include scaling coefficients by inflation (alternative 1) and scaling them according to the hypothetical ‘reference bank’ used to calibrate the surcharges in 2015 (alternative 3).

The smallest reduction in G-Sib scores would be the simple update, followed by the actual proposal. Indeed, when set against reductions from the other alternatives – 30.1% from inflation-adjustments and 33.2% from the reference bank option – the proposal appears comparatively modest.

But even these alternatives pale beside the economic growth projection, which would cause G-Sib scores to plummet 43.4%.

In other words, the Federal Reserve’s proposal for the G-Sib surcharge will be much more deregulatory in future than it is in the immediate term, and more so than any of the reasonable alternatives put forward by the Fed.

These projections include reform of the short-term wholesale funding (STWF) indicator, which removes the benchmark against risk-weighted assets (RWAs) and introduces a coefficient designed to permanently fix the indicator at 20% of a bank’s systemic risk.

In addition to slashing G-Sib scores on its own merits, this accentuates the impact of the reduction in coefficients, as lower coefficients mean lower scores, which in turn means the STWF coefficient will be further reduced over time to keep the STWF indicator at around 20% of the total score.

Among objections to the reform, Fed governor Michael Barr suggests banks being more reliant on STWF than the Fed had expected when setting the 20% target, could be seen as a sign that “the problem the Board was trying to deal with was bigger than initially believed”, and not a reason for the reforms to be rowed back.

The Fed projects that method 2 surcharges will be higher than method 1 for six of the eight banks, so the US will continue to have higher requirements in the immediate term. But the proposal still represents a much lighter-touch regime, particularly when looking ahead at the impact of adjusting coefficients by economic growth. 

Only time will test its fitness. Or, indeed, whether someone has blundered.