Blog Post

Is the United States reneging on international financial standards?

The new Fed rule is a material breach of Basel III, a new development as the US had hitherto been the accord’s main champion. This action undermines the global order without being ostensibly justified by narrower considerations of US national interest.

By: Date: April 16, 2020 Topic: Banking and capital markets

The financial shock surrounding the COVID-19 pandemic has prompted the US Federal Reserve to temporarily loosen an important capital-to-asset ratio requirement for American banks. In so doing, the US is walking away from a decade-long commitment to global financial reform that it made in the wake of the global economic meltdown of 2008-10.

This breach, together with other recent US government actions, might signal a broader departure from the Trump administration’s general adherence in its first three years to international financial standards, an area in which it had so far not acted against the global rules-based order. The motives for the breaches are not compelling enough to offset the downsides for the global financial system and for the United States itself.

The new Fed rule breaches the Basel III Accord

On 1 April, the Federal Reserve announced a temporary change to a regulatory requirement on banks, known as the supplementary leverage ratio (or simply the leverage ratio). The leverage ratio, calculated as regulatory capital (or own funds) divided by unweighted assets, supplements the more refined ratios of capital to risk-weighted assets, which are the mainstay of bank capital regulation. While a crude measure of capital strength, the leverage ratio is an apt response to the incentives banks have to underestimate risk-weights. It acts as a simple sanity check, thus the epithet ‘supplementary.’

The new change, which the Fed adopted unanimously, exempts banks’ holdings of US sovereign debt (Treasuries) and deposits at the Fed from the assets total in the ratio calculation, until end-March 2021. This exemption reduces the denominator, making it easier for banks to meet their minimum-ratio requirements during that period. By exempting sovereign exposures, the rule deviates from the internationally agreed definition of the leverage ratio that is part of the Basel III accord, initially published in 2010 by the Basel Committee of Banking Supervision on the back of a mandate given by the G20 in 2008-09.

The Fed’s decision echoes separate congressional action in the Coronavirus Aid, Relief, and Economic Security (CARES) Act, which was signed into law on 27 March 2020. Section 4014 of CARES gives banks the option of ignoring an accounting obligation known as current expected credit loss (CECL) provisioning. Most banks started implementing this obligation in January 2020. CECL was introduced in response to a 2009 mandate from the G20, which was implemented in 2016 by the US Financial Accounting Standards Board (FASB), and separately earlier in 2014 by the International Accounting Standards Board (IASB), whose standards are applied in most jurisdictions other than the United States. By opting out of CECL, banks can avoid booking losses that are expected from the dramatic deterioration in the economic outlook from the pandemic and can thus make their capital positions look correspondingly more flattering.

The Fed’s rule change and the Congress’s action in the CARES Act suggest an incipient trend of US departures from the comprehensive package of global financial standards enacted by various bodies under the G20’s authority since 2008. One earlier signal of this came in November 2019, when the Fed and other federal bank regulators made a change – also in breach of Basel III – to an arcane rule on measuring counterparty credit risk in certain transactions.

To be sure, the United States is far from the only offender, let alone the worst. Most notoriously, in 2014, the Basel Committee found the European Union materially non-compliant with Basel III, the only jurisdiction in that category – partly for similar counterparty-credit-risk shenanigans as with the US rule of November 2019. Nor are the recent American breaches wholly unprecedented, if one goes far enough back. In the years before the 2008-10 financial crash, US authorities were reluctant to adopt the previous Basel II accord, for prudential reasons that the subsequent crisis experience largely vindicated. But from the first G20 summit in late 2008 up to recent months, the United States was the leading champion of G20 financial reform, and that compliant stance was maintained under the first few years of the Trump administration. Even as some financial rules were relaxed, they were kept above the minimum levels set in international accords. Indeed, the final bits of Basel III were agreed in December 2017 after Randal Quarles, a Trump appointee, replaced his Obama-era predecessor Daniel Tarullo as the Fed’s point person in Basel Committee discussions.

The motivations for these changes are unconvincing

The US departures from global standards respond to specific demands from the US banking industry and some federal agencies, but whether they are in the US national interest is questionable. The experience so far of the COVID-19 crisis is precisely that strong capital standards, such as Basel III, are helpful protections against unforeseen events. Globally-applied minimum prudential standards ensure a degree of international financial stability from which the United States benefits. Standards also prevent the most blatant competitive distortions in international banking markets – a key driver of the first Basel accord in the 1980s. It is not clear that the leverage ratio breach has benefits that offset the loss of such advantages.

The motivations for the Fed’s new rule appear to include the fact that the pandemic-induced volatility has disrupted the Treasuries market and has also resulted in a sudden influx of deposits into US banks. If banks are less constrained by the leverage ratio limit, so the thinking appears to go, they can buy more Treasuries and thus contribute to more orderly markets. But it is doubtful that leverage-ratio-related constraints played any role in the recent Treasuries market turmoil. As for the incoming deposits, banks can place them into deposits at the Federal Reserve, rather than Treasuries. A temporary exemption for such central bank deposits from the leverage ratio would not have breached Basel III in its current form. Moreover, the exemption for US sovereign exposures creates a highly problematic precedent that other jurisdictions with less creditworthy sovereign issuers might now be tempted to emulate, against the Basel Committee’s efforts to move its members towards consensus on a more rigorous recognition of the risks that such exposures might carry. Similarly, concerns about procyclical impacts of CECL could and should have been addressed by using the standard’s embedded flexibilities, similar to what was recommended outside the United States by the IASB and implemented by the euro area and the United Kingdom, among others.

By breaching G20 standards, these decisions contribute to institutional erosion at the global level and domestically. The breaches of Basel III are especially galling since Quarles now chairs the Financial Stability Board, an umbrella body whose permanent secretariat is located in the same building in Basel as the Basel Committee. On the domestic front, the Fed also acted alone, as the other federal banking regulators, including the Office of the Comptroller of the Currency and the Federal Deposit Insurance Corporation, did not endorse its new rule as is customary. The congressional override of FASB (and, in the same move, of the US Securities and Exchange Commission, which delegates to the FASB standard-setting authority), also is without precedent in nearly half a century.

The United States would lose from abandoning global financial standards

Possibly the recent breaches are one-offs, not the start of a broader trend of divergence. In a formal sense, both the Fed’s action on leverage ratio and Congress’s on accounting are temporary measures, even though they could be extended. They could, however, mirror a broader current pattern of the United States undermining the global rules-based order, from which the financial services area has been somehow ring-fenced until now. Be that as it may, these breaches are bad news for the authority of the G20, the Financial Stability Board and the Basel Committee, but are probably not crippling. Just as US agencies did not implement Basel II, and the FASB has declined to converge its standards with the IASB’s global standards, global financial standard-setting bodies can probably live with US lapses of compliance, at least for some time. It remains to be seen, however, how the implementation of the final piece of Basel III, which the Basel Committee has recently decided to delay by a year because of the COVID-19 pandemic, will be ultimately affected by an eclipse of US leadership in that area.

If the noncompliance trend is confirmed, the most damaging consequences could be to the United States itself. The chair of the foundation that hosts and oversees the FASB, in a letter that unsuccessfully attempted to persuade Congress not to pass Section 4014 of the CARES Act, argued that the action fundamentally undermines the longstanding and time-tested approach in the U.S. to transparent, rigorous and independent accounting standard-setting, which market participants rely upon and that plays a critical role in supporting our capital markets and broader economy.

The United States has benefited immensely from upholding best-in-class financial standards and regulations. If these standards are lowered, US economic achievements, all things equal, might be undermined as well.


Republishing and referencing

Bruegel considers itself a public good and takes no institutional standpoint. Anyone is free to republish and/or quote this post without prior consent. Please provide a full reference, clearly stating Bruegel and the relevant author as the source, and include a prominent hyperlink to the original post.

Read article More on this topic More by this author
 

External Publication

Country case studies on resolving problem loans in Europe: Crises, policies and institutions

Contribution to 'Nonperforming Loans in Asia and Europe—Causes, Impacts, and Resolution Strategies' published by the Asia Development Bank.

By: Alexander Lehmann Topic: Banking and capital markets Date: December 3, 2021
Read about event More on this topic
 

Past Event

Past Event

Fiscal policy and rules after the pandemic

What are the possibilities for shaping the new fiscal policy?

Speakers: Zsolt Darvas, Maria Demertzis, Michel Heijdra and Katja Lautar Topic: Macroeconomic policy Date: November 24, 2021
Read article More by this author
 

Blog Post

Fiscal arithmetic and risk of sovereign insolvency

The record-high debt levels in advanced economies increase the risk of sovereign insolvency. Governments should start fiscal consolidation soon in an environment of low nominal and real interest rates and post-COVID growth.

By: Marek Dabrowski Topic: Global economy and trade, Macroeconomic policy Date: November 18, 2021
Read article More on this topic More by this author
 

Podcast

Podcast

Pandemonium

How did Europe respond to the pandemic?

By: The Sound of Economics Topic: European governance Date: November 17, 2021
Read about event More on this topic
 

Past Event

Past Event

Phasing out COVID-19 emergency support programmes: effects on productivity and financial stability

How can European countries phase out the COVID-19 support measures without having a negative impact on productivity and financial stability?

Speakers: Eric Bartelsman, Maria Demertzis, Peter Grasmann and Laurie Mayers Topic: Macroeconomic policy Date: November 9, 2021
Read article More on this topic More by this author
 

Blog Post

What to make of the EU-US deal on steel and aluminium?

While deeply disappointing that the surprise deal maintains aluminium and steel tariffs against the EU beyond a modest quota, it alleviates a major irritant in transatlantic relations and contains interesting and innovative features relating to climate policy and to dispute settlement under WTO rules.

By: Uri Dadush Topic: Global economy and trade Date: November 4, 2021
Read article Download PDF
 

Policy Contribution

European governance

COVID-19 financial aid and productivity: has support been well spent?

While support schemes during the pandemic were not targeted at protecting ‘good’ firms, financial support mostly went to those with the capacity to survive and succeed. Labour schemes have been effective in protecting employment.

By: Carlo Altomonte, Maria Demertzis, Lionel Fontagné and Steffen Müller Topic: European governance, Macroeconomic policy Date: November 4, 2021
Read article
 

Blog Post

European governanceInclusive growth

The socioeconomic effects of COVID-19 on women

The pandemic has disproportionately affected women both professionally and at home. Although the gender gap in labour force participation since the onset of the pandemic hasn't worsened, policy still needs to tackle existing gender gaps, which for some EU countries are very substantive.

By: Maria Demertzis and Mia Hoffmann Topic: European governance, Inclusive growth Date: November 3, 2021
Read article More on this topic
 

External Publication

Elimination versus mitigation of SARS-CoV-2 in the presence of effective vaccines

Article published in Lancet Global Heath on strategies to end the COVID-19 pandemic in the presence of effective vaccines.

By: Miquel Oliu-Barton and Guntram B. Wolff Topic: Global economy and trade Date: November 3, 2021
Read article
 

Blog Post

European governance

Is the risk of stagflation real?

Most economic forecasts predict a return, in the medium-term, to pre-pandemic growth and inflation. Nevertheless, the European Central Bank and fiscal authorities need to be vigilant for signs of the contrary.

By: Monika Grzegorczyk, Francesco Papadia and Pauline Weil Topic: European governance, Macroeconomic policy Date: November 2, 2021
Read article More on this topic
 

Blog Post

Strong, balanced, sustainable and inclusive growth? The G20 and the pandemic

The G20 is not doing enough to support strong, balanced, sustainable and inclusive growth in the wake of COVID-19, with the poorest countries left behind by the recovery.

By: Suman Bery and Pauline Weil Topic: Global economy and trade Date: October 29, 2021
Read article Download PDF
 

Parliamentary Testimony

European ParliamentInclusive growth

Understanding the socioeconomic effects of the COVID-19 pandemic on women

Testimony before the European Parliament's Committee on Economic and Monetary Affairs (ECON) on the consequences of the pandemic on women.

By: Maria Demertzis and Mia Hoffmann Topic: European Parliament, Inclusive growth, Macroeconomic policy Date: October 27, 2021
Load more posts