Fed's Waller says capital plan should be withdrawn

Bess Adler/Bloomberg

A key Federal Reserve official said regulators should consider pulling their proposed capital framework for large banks to make substantial changes. 

During a virtual event hosted by the Brookings Institution on Tuesday, Fed Gov. Christopher Waller expressed fundamental concerns about the so-called Basel III endgame proposal issued last summer. He said efforts are being made to address a variety of issues, but noted that there may be too many issues.

"The blowback we've seen from the banking industry and [Capitol] Hill has shown that this is not necessarily a good rule — proposed rule — as it stands now," Waller said. "So, it's gotta have a major overhaul in my view to get a reasonable product, and possibly just taking it back and starting over."

Waller's remarks occurred on the final day for the public to weigh in on the Basel III endgame plan. The proposal would make a variety of changes to how risk-based capital charges are calculated, chiefly by replacing internal models with standardized ones for all banks with at least $100 billion of assets.

Waller and Fed Gov. Michelle Bowman in July voted against the proposed rule change, which was endorsed by four Fed board members and simultaneously issued by the Office of the Comptroller of the Currency and Federal Deposit Insurance Corp. On Tuesday, Waller raised two main concerns.

First, he said U.S. regulators stand to fall short of the Basel Committee on Banking Supervision's core mission of "harmonizing" regulatory standards — an exercise he and others view as being focused on bringing other jurisdictions up to the U.S. level of regulatory scrutiny. 

"European banks, U.K. banks were not going to carry through. We decided to go ahead — that's not harmonizing," Waller said, referring to reforms at the Bank of England and the European Central Bank that would result in more modest increases in aggregate capital. 

Waller's second and more pointed criticism of the proposal was its treatment of operational risk, or losses that could arise from lawsuits, natural disasters, cyberattacks, fraud or other misdeeds by bank employees or executives. He worries that the rule, as currently written, would limit banks' ability to extend credit. 

Regulation and compliance

Bowman, Waller vote against Fed's Basel III endgame proposal

July 27, 2023 12:55 PM

"We're basically going to impinge on capital market functioning, both in terms of products, services and pricing. I don't understand why we want to do that [for something that is not] seriously showing any threats," Waller said. "I made a big deal about operational risk, which is more than half of the increase, and the way it's calculated made absolutely no sense to me whatsoever."

Banks and their allies have argued that the formula for determining operational risk capital is punitive. The amount of capital banks must hold is increased by recent past operational losses, while also being subject to a floor that would prevent banks with fewer operational losses from having lower capital requirements. 

Regulators and their supporters argue that past operational issues are often a good indicator of future losses. They also note that allowing large banks to create their own models for such risks — as is the case currently — allows for too much variability throughout the banking system.

Waller said Fed officials are working on addressing issues with the proposal and will accelerate their efforts once the public comments are compiled and considered. He also reaffirmed Fed Chair Jerome Powell's commitment to reaching consensus on the final rule before putting it to a vote.

"[Powell] has said we want to have products go out with broad support on the board. That may be possible, if enough major things get redone, that we could get a broad support for it," he said. "But, it's got to have a lot of work, and like I said it might be best to just pull it back and then work on this and then put it back out at a later date."

Waller also weighed in on the Fed's recent change to Regulation II (pronounced "eye eye"), which amends the cap that banks are allowed to charge merchants for debit card transactions. He said he wishes "Congress never gave us the responsibility" for setting the cap on fees. But since it did, Waller said, his goal was to follow the letter of the law as closely as possible; he added that he feels the board was successful in doing so.

After collecting data from throughout the banking system on the true costs associated with processing debit transactions, Waller said, the Fed determined it was appropriate to lower the cap. 

"I don't want to pick winners and losers — there's no fun in having to do any of that — but Congress told us to do it, and we kind of just did it again, like we did roughly 14 years ago," Waller said. "So, I just try to keep the very focused, narrow legal view that Congress did and we're following that to a T."

Waller also weighed in on the Fed's effort to reduce its balance sheet by allowing assets to roll off without replacing them — a process known as quantitative tightening — which has drained $1.3 trillion from the central bank's holdings since the spring of 2022. 

The Fed's balance sheet drawdown may be happening faster than expected

Though recent developments have caused some Fed officials to question whether it is time to start thinking about curtailing their QT policies, Waller said he is confident the balance sheet can be reduced at least $2 trillion from its peak level. He added that while he could foresee scaling back the runoff of Treasuries this year, he would like to see the Fed drop mortgage-backed securities from its balance sheet for as long as it can. 

"I don't think we need to taper the pace on MBS; we're not even hitting the cap … I, personally, don't really want to keep MBS on the balance sheet, so I'm all in favor of letting MBS kinda just continue to run off at the current pace," he said. "But Treasuries, we could start tapering that back and get reserves to where we want."

Waller said there is no leading theory about how large or small a central bank's balance sheet can or should be, so long as reserves — funds commercial banks keep at the Fed — remain ample. He added that a large balance sheet has no bearing on the financial system, but its presence could fuel the misconception that the Fed is in some way holding back the economy by carrying so many assets. 

"The optics of this are just bad. It has nothing to do with monetary policy at all [or] its effectiveness. Nothing. But, it just kind of looks bad when you're not turning over any seigniorage revenue to the Treasury, and you're delaying when you'll start doing it," he said. "And for that reason, you may want to think about not keeping your balance sheet too big, but that's … one of the few reasons for doing [QT]."