It is crucial for banks to maintain sufficient loss-absorbing capital buffers to weather the next economic downturn. Research shows, however, that bank capital levels are still too low. It is particularly important for regulators to address this issue promptly given the economy’s position in the business cycle.
The U.S. economy is in its ninth year of the post-financial crisis economic expansion. As with most prolonged expansionary periods, risks are building under the surface despite rosy topline economic figures. The Federal Reserve must tighten financial safeguards during this economic boom. The first step should be activation of the countercyclical capital buffer (CCyB) — an additional loss-absorbing equity buffer for the largest banks in the country.
One of the truisms in banking is that the worst loans are made during the best times.
As the economy continues to expand and move toward the later stages of the economic cycle, risks typically build in the financial sector. Business leverage increases, banks loosen underwriting standards, and spreads for riskier assets narrow. Eventually, these risks come to the surface during the ensuing economic downturn, elevating bank losses.
Experience over the previous several centuries of financial history shows that just as these risks mount in booming economic times, policy makers tend to ease regulations on financial firms. This held true during the South Sea bubble in the early 1700s, during the decades before the 2007-2008 financial crisis, and during most economic expansions in between.
Following the 2007-2008 financial crisis, policy makers recommitted to combatting this historical trend by endorsing a countercyclical approach — tightening financial regulatory requirements during economic expansions as risks build in the financial system.
The countercyclical capital buffer is one tool regulators established after the crisis to implement this approach, applying to banks with more than $250 billion in assets or $10 billion in on-balance-sheet foreign exposure and can be raised up to 2.5% of risk-weighted assets. The Fed, in consultation with the other banking regulators, can activate the buffer when the risk of above-normal losses in the banking sector is on the horizon.
Current economic conditions warrant activation of this buffer. As Fed Chairman Jerome Powell stated at a recent congressional hearing, valuations across asset classes are high.
This year, the Shiller price-earnings ratio—which compares a company’s stock price to its earnings — reached its highest level since the dot-com bubble of the late 1990s. The spreads between high-yield debt and high-grade debt have narrowed considerably over the past few years and are tighter than at any point since the financial crisis. Commercial real-estate price indices show CRE valuations are also at or near their peak levels.
Corporate debt is sky-high as nonfinancial companies have taken on significant leverage in the decade since the financial crisis. The amount of corporate bonds outstanding for U.S. companies has increased by $2.7 trillion over the past five years and currently sits at a record $6.3 trillion, with 2017 setting a record for corporate-bond issuance. Moreover, commercial bank business loans outstanding have increased by roughly 20% adjusted for inflation since their pre-crisis peak.
Whether this massive level of outstanding corporate debt is compared to gross domestic product or to measurements of corporate earnings, current debt levels meet or exceed pre-financial crisis highs. Companies may have difficulty refinancing this debt as interest rates rise and the debt matures in the coming years, which raises the probability of corporate defaults.
In addition to the staggering amount of corporate debt outstanding, the credit quality of the firms taking on this leverage has deteriorated.
Since the financial crisis, high-grade corporate debt outstanding has fallen by over 30%, while medium-grade debt has increased by 120% since 2011. Junk-rated debt outstanding has almost doubled since 2006 to about $1.2 trillion today. The leveraged loan market, another way for highly indebted companies to borrow, has also set records and surpassed the junk-bond market in 2018 at over $1.2 trillion.
Beyond the ballooning size of these markets, the provisions included in bond and loan contracts meant to protect lenders have been watered down in recent years. These watered-down covenants may lead to increased losses for lenders if a company defaults.
Bank underwriting generally has also weakened in the past few years. The Office of the Comptroller of the Currency highlights loosened underwriting standards as one of the key risks facing the banking sector. Moreover, consumer debt is set to surpass $4 trillion for the first time later this year and is higher than it was in the mid-2000s as a percent of annual income. Notably, the Consumer Financial Protection Bureau reported that credit-card debt among subprime borrowers has increased by 26% over the past two years.
Some of the previously outlined economic trends are global, and other countries — including the U.K., France, Ireland, Norway, and Sweden — have already activated the countercyclical capital buffer incrementally for their banks.
In the U.S., several regional Fed bank presidents, including Eric Rosengren,Charles Evans,Loretta Mester, and Esther George have all endorsed activating the countercyclical capital buffer. Additionally, Fed Gov. Lael Brainard has stated that it may soon be time to activate the CCyB. Moreover, the countercyclical capital buffer is a far better policy tool to address these developing risks than raising interest rates, which is a blunt instrument.
It is anyone’s guess as to what specifically will spark the next economic downturn or when it will occur. During these positive economic times, regulators must lean into the wind and strengthen financial safeguards — including loss-absorbing capital buffers.
Unfortunately, regulators have followed the historical trend by proposing to chip away at key pieces of the post-crisis bank capital regime. The Fed should refrain from finalizing any rules that would lower bank capital and instead activate the CCyB promptly.
Gregg Gelzinis is a research associate for economic policy at the Center for American Progress.