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A Recollection of the Past Year
As we progress through the COVID-19 pandemic, the economy and financial system are a long way from being fully healthy. Within the past year, businesses’ weaknesses were exposed more than ever before. This was clearly seen as the tourist and airline industry experienced existential threats to their business operations. Financial uncertainty was not exclusive to these industries as the pandemic sent repercussions all throughout the banking system. About this time last year, the financial market was crippling as a global economic recession seemed imminent due to the spread of COVID-19. In the eyes of America’s central bank, “it was a clear signal that the 2020 meltdown echoed the 2008 crisis in seriousness and complexity” (Smialek).
At the time, removing the capital requirements for banks seemed necessary in order to avoid any impending disasters. Getting rid of this requirement meant that banks had “the temporary ability to exclude Treasurys and deposits held at the central bank from lenders’ so-called supplementary leverage ratio” (Ackerman and Benoit). In the short-term, it allowed banks to make loans to businesses and households through the reallocation of funds (Ip). The central bank also kept interest rates low, bought corporate debt, and gave loans to midsize businesses. These last two actions have never been done before by the Federal Reserve and it extended their role as the lender of last resort (Smialek).
Where We Are Now
Fed officials announced on March 19th, 2021 that they will stop providing emergency relief to big banks. In the eyes of the central bank, the markets have stabilized enough in the past year to move forward with this reversal. This decision did not come with welcoming arms though as some believe that more assistance is needed to ensure a full recovery. These individuals argue that a change in the capital requirement serves “no purpose” because banks are already well-capitalized even without including Treasurys and reserves as assets (Ip). By enforcing this new requirement, it would also prevent financial activity as banks are forced to “a minimum of 5% capital against all assets” (Ip).
It is difficult to know at the moment if the central bank is moving too quickly with this change. The adjustment to the capital requirement is a balancing act since it will disincentivize investments and slow down the economy if it is at too high of a level. On the other hand, having the capital requirement too low can make the economy run hot and make it susceptible to recessions. Relaxing the capital requirement for banks could also encourage them to take on more risky assets, which can lead to bankruptcies if these investments fail.
The capital requirement is in place to ensure that the banking system will remain liquid and solvent during times of financial distress. Especially after the Great Recession and the implementation of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the capital requirement is necessary to avoid defaults and the possible destruction of our economy. By keeping capital on hand, it acts as an emergency fund for when a bank experiences operating losses. Put simply, it is evident that a capital requirement serves a purpose as it prevents reckless behavior by banks.
Conclusion
Finding the perfect percentage of capital to hold against assets is a difficult task for Fed officials. That being said, the argument that it serves no purpose is a misleading statement because it does serve an important and defined purpose of keeping the markets dependable. It does inhibit a bank’s ideal way of running its operations, but it is necessary to create a sustainable financial environment. The central bank may have acted too early in the reversal of the capital requirement, but the current balancing act prevents banks from taking on risky assets during a time of financial instability.
Sources:
Andrew Ackerman and David Benoit: https://www.wsj.com/articles/federal-reserve-to-end-emergency-capital-relief-for-big-banks-11616158811#:~:text=Big%20U.S.%20banks%20must%20maintain,levels%20to%20cover%20potential%20losses.?mod=article_inline
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