Sen. Warren is Wrong about Raising an Additional Bank Capital Buffer 

In a letter addressed to Federal Reserve Board Governor Lisa Cook on August 7^th, Senator Elizabeth Warren (D-Ma.) urged the board to activate a regulatory mechanism known as the Countercyclical Capital Buffer (CCyB). Senator Warren seeks a solution to an imagined problem. The data do not justify the CCyB, and raising it would only signal financial stress, manufacturing the very risk she claims to fear.  

The countercyclical buffer is designed to be implemented in times of heightened economic stress to weather financial instability. The buffer would increase mandated Common Equity Tier 1 Capital (CET1) holdings relative to risk-weighted assets by 2.5% for banks with over $250 billion in assets. However, since its adoption in 2016, the Fed has never needed the CCyB, and current conditions do not warrant its activation, despite Senator Warren’s concerns.  

Background 

Under Dodd-Frank, the CCyB is permitted when systemic vulnerabilities within the financial system are significantly above normal. The protocol does not explicitly define any numerically objective tests or criteria to assess whether it is warranted. The relevant statute encourages a holistic assessment of macroeconomic indicators such as credit and liquidity expansion or contraction, trends in real estate prices, or the credit to GDP ratio. 

Senator Warren’s letter failed to contextualize important statistics about equity markets and macroeconomic indicators such as inflation and unemployment. Inflation has declined from a staggering 9% under the Biden administration to under 3%. While the past few months of jobs reports faced downward revisions, the unemployment rate remains low, hovering around levels last seen in 2017. Monthly jobs and inflation reports only capture a snapshot of the economy at a certain point in time. When interpreted over the long run, there is no evidence that the U.S. economy is facing a serious spike in either inflation or unemployment. That sentiment is reinforced by the Fed’s stance on keeping rates unchanged for the past five FOMC meetings. 

Senator Warren’s perspective on asset markets registered as misapprehensive. The senator noted potential signs of overvaluation in the stock market as a red flag suggesting the need for immediate regulatory intervention. While the cyclically adjusted price-to earnings-ratio of the S&P 500 is high relative to its historical average, the dynamics of the stock market have shifted, supporting higher valuations. U.S equities have consistently outperformed Europe and other global markets thanks to investments in intangible assets, which have lower marginal costs and synergies that support the prospect of increasing future earnings growth. Asset prices reflect market beliefs about future earnings growth, and the U.S leads in several key high-growth sectors such as AI, allowing for the U.S market to be priced at a premium compared to the rest of the world.  

Overvaluations should not be conflated with “systemic risks” associated with events such as the dot com bubble or the global financial crisis. Expensive equity valuations are insufficient to justify the claim that markets are steeped in a bubble if the drivers behind those valuations can be discerned and identified.  

Fed Report Disagrees 

The Federal Reserve’s Financial Stability Report, published in April, refutes Senator Warren’s notion of an economy imperiled by excessive speculation and leverage. The report’s highlights do not endorse Senator Warren’s view that financial stability is vulnerably positioned. Among its key takeaways, it notes that “total debt of businesses and households as a fraction of GDP continued to trend down to its lowest level in the past two decades”, and that “most household debt is owed by borrowers with strong credit histories”.  

The report also allays Senator Warren’s alarmist rhetoric on corporate bond risks, with the Fed observing that “corporate bond spreads have widened significantly but have stayed at or below their historical medians”. Additionally, the bond premium for all nonfinancial corporate bonds “continued to be near to its long-run average”.  

According to data from the St. Louis Fed, Total credit to the nonfinancial sector as a percentage of GDP has declined since 2020, and continues to trend downwards, reaching its lowest level since 2002. Senator Warren cites the fact that corporate leverage has decreased from a 2020 peak of 92% of GDP to 85%. Her own evidence suggests the private sector is sustainably deleveraging in its recovery from the pandemic induced recession. 

Households also pay less debt as a percentage of disposable income than they did in the years leading up to the dot com bubble or the global financial crisis. Often seen as one of the hallmarks of financial stress, household balance sheets contradict Senator Warren’s portrayal of an economy awaiting imminent implosion. 

Annual stress tests have continued to demonstrate bank sector resilience. The most recent findings concluded that systemically important banks are well capitalized and hold enough liquidity to weather crisis scenarios such as an unprecedented capital outflow or a recession. The Fed’s April report also noted banks hold more capital than statutorily prescribed thresholds, rendering the premise of Senator Warren’s argument untenable.  

Conclusion 

Activating the CCyB would only increase the volatility and systemic vulnerabilities that Senator Warren claims to be interested in lessening. The market would interpret the Fed’s action as an indicator of heightened systemic vulnerability, incentivizing erratic market behavior in response to that signal. Markets watch the Fed due to its outsized influence on the economy. Sending the wrong message could have adverse implications for economic growth and lending, which is why it is important that the Fed avoids selecting the wrong policy lever at the wrong time.  

Policymaking in the financial sector should be calibrated to reflect economic reality. It would be unwise for the Fed to levy a punitive capital buffer under the backdrop of stable economic growth and a well-capitalized financial sector. Politicians should likewise avoid taking cheap shots at an overregulated industry. In seeking to solve a non-existent issue, Senator Warren may manufacture a real one.