OFR Paper Questions Whether Higher Capital Standards Reduce Bank Risks

An Office of Financial Research (“OFR”) working paper examined how risk-taking in the repurchase agreement (“repo”) market changed after the introduction of the Basel III supplementary leverage ratio (“SLR”) regulation for banks. The working paper found that broker-dealers owned by U.S. bank holding companies (“BHCs”) now borrow less in the repo market overall after the change, but a larger percentage of the borrowing is backed by more risky collateral.

The working paper considered that:

  • in theory, the SLR could incentivize BHC-owned broker-dealers subject to the SLR to: (i) reduce their activity in the repo market; (ii) reduce their use of lower risk collateral, such as government securities, to back repo; and (iii) increase their use of more price volatile collateral, such as equities;
  • such a change of behavior may: (i) have the unintended effect of reducing liquidity in the agency mortgage-backed securities (“MBS”) market; (ii) reduce the stability of BHC-affiliated broker-dealers’ repo funding, by limiting the ability to migrate triparty financing to blind-brokered and centrally-cleared repo venues in times of stress from a greater use of repo funding backed by non-government securities collateral; and (iii) encourage non-affiliated broker-dealers to play a large role in the repo market even as their regulatory regime has changed little post-crisis;
  • the leverage ratio as a risk-insensitive capital standard may encourage firms to increase the risk profile of their remaining activities – the SLR-driven results are relevant to ongoing policy discussions internationally about potentially increasing leverage ratio requirements for global systemically important banks;
  • regardless of whether a U.S. BHC-owned broker-dealer parent is above or below the SLR requirement, the announcement of this rule has disincentivized those dealers affiliated with BHCs from borrowing in triparty repo, particularly using Treasuries and agency MBS as collateral, and incentivized them to use riskier equity collateral; and
  • nonbank-affiliated broker-dealers are entering the repo market following the announcement of the SLR.

The working paper concluded:

Thus, the activity and importance of nonbank-affiliated broker-dealers in the triparty repo market appears to be growing in response to more stringent BHC capital standards that affect bank-affiliated dealers through consolidation.

This finding is persistent and may suggest the need to revisit regulatory requirements for broker-dealers, which have been subject to little change since the 2007-09 crisis, to prevent a buildup of risks in nonbank-affiliated broker-dealers.


Lofchie Comment: This paper demonstrates one of the more obvious flaws of the bank regulators’ new capital liquidity rules: simplistic, crude regulations (that do not distinguish between assets on the basis of their risk) have the effect of disincentivizing banks from holding safe assets, as opposed to risky assets, because both receive the same regulatory treatment. More specifically, the bank regulators have imposed regulations that are doing significant damage to the repo market for U.S. government securities and agency MBS market.  (For a defense of these capital liquidity requirements, see FDIC Vice Chair Defends Higher Leverage Ratio.)

Having demonstrated that the liquidity requirements have done damage to bank-affiliated broker-dealers, however, the paper seems to suggest that the same type of regulations should be extended to broker-dealers not affiliated with banks. The basis for this leap in logic is not clear. If a regulation is not working as intended, wouldn’t it make more sense to roll back the regulation going forward after receiving this feedback, rather than to extend it?