From Basel To Baffling: It's Time To Simplify Bank Capital Rules

Forbes

5 days ago

UNITED STATES - APRIL 10: Michelle Bowman, nominee to be Vice Chairman for Supervision, Board of ... More Governors of the Federal Reserve System, arrives for her confirmation hearing in the Banking, Housing, and Urban Affairs Committee in the Dirksen Senate Office Building on Thursday, April 10, 2025. (Bill Clark/CQ-Roll Call, Inc via Getty Images)
This past week, thanks to the efforts of Fed Vice Chair for Supervision Michelle Bowman, the Fed hosted a conference titled the 'Integrated Review of the Capital Framework for Large Banks.' In his opening remarks, Fed chair Jerome Powell announced that the Fed is open to hearing new ideas and feedback on how to improve the capital framework, and he stressed the importance of reviewing the whole framework rather than examining its elements in isolation.
This is a welcome bit of news after the controversial 2023 proposal to implement Basel III endgame. It's also a golden opportunity for the Trump administration to hugely improve the financial regulatory framework.
Virtually every panelist at the conference agreed that the existing system is too complicated. But 'too complex' is a gross understatement. The existing system is a total mess. It contains volumes of rules with mind-numbingly complex details, many of which are (at best) redundant. It includes ill-defined concepts such as reputational risk and operational risk that contribute no marginal benefit to the basic capital and liquidity rules. It's very easy to make a case for scrapping the whole thing and starting over.
Capital Framework Jenga
The regulatory framework looks and feels sort of like a Whac-A-Mole board because that's kind of what it is—it's been cobbled together over decades by stacking new rules on top of old rules as new problems pop up. But regulators rarely get rid of the outdated leftovers. And while banks now have more and higher capital requirements than they did in the past, that does not equate to a better system.
Higher capital requirements are costly and can create perverse incentives. Moreover, requiring higher capital does not automatically stabilize the financial system or prevent government bailouts. It's easy to forget, but U.S. commercial banks exceeded their minimum capital requirements by 2 to 3 percentage points (on average) for six years leading up to the 2008 financial crisis.
More recently, when Silicon Valley Bank failed in 2023, their liquidity position was strong enough to meet more stringent liquidity rules. In both cases, though, financial turmoil resulted in regulatory overreaction.
A Simple Capital Framework is Better
As far as the bank capital framework goes, the community bank leverage ratio is one of the only good things to come out of the post-Dodd-Frank era. This provision, signed into law and implemented during the first Trump administration, allows small banks (those with up to $10 billion in total assets) an escape hatch from the complicated capital framework.
All they have to do is agree to meet a higher, simpler ratio. And many of them happily took the tradeoff. (As of last year, according to discussions with the Federal Deposit Insurance Corporation, almost 40 percent of small banks took the deal.) It is unlikely that many of the largest and most complex banks would want to go this route, but federal regulators could still offer the choice.
Regardless, there are many other ways that federal regulators could radically improve the existing system by simplifying it.
For instance, the existing capital framework includes a standardized approach and an advanced approach. Neither one will ever be perfect, so just pick one and ditch the other one.
The existing framework includes a common equity tier 1 ratio, a tier 1 capital ratio, and a total capital ratio. Just pick one.
The existing framework has a risk-weighted leverage ratio, a supplemental leverage ratio, and an enhanced supplemental leverage ratio. Just pick one.
The existing framework includes a stress capital buffer and a capital conservation buffer, figures that are added to the above-mentioned capital ratios. Ditch the buffers—if the capital ratio is too low, raise it.
If the ratios are higher for the largest banks (the so-called Global Systemically Important Banks, or GSIBs), then the regulatory agencies can make these suggested changes without any new legislation. The framework would be much simpler and there's no objective reason this kind of simplification would weaken or destabilize the financial sector.
In the interest of full disclosure: Some of these ideas for simplification are not entirely original. And, of course, there's much more that the agencies and Congress could do.
Reforms Needed Beyond Capital Framework
For instance, regulators could create a materiality threshold for all safety and soundness risks, as well as a materiality threshold for all federal regulatory directives, including Matters Requiring Attention. Even better, Congress could eliminate the ability of federal regulators to use reputational risk in their examinations.
There's also very good reason to stop focusing so much on the capital framework for bank holding companies instead of those for the bank itself. That part of our system is really a holdover from the days when branch banking was prohibited, but that hasn't been the case since the 1990s.
Congress could also drop supervisory stress testing. A simplified capital framework could be more easily reviewed each year or two, without having to worry about making changes based on the stress test results, and banks can publicize their own stress tests results if they like. (If they really feel like they must, banking regulators could still use stress tests, in the absence of a legal requirement, to adjust a slimmed down system every few years.)
Some might view these changes as too risky or radical, but the risk-weighted capital framework wasn't formally a part of the U.S. system until the 1980s. Risk-weights will always be subject to error, and nobody should be under the impression a risk-weighted system can't lead to harmful outcomes.
Dodd-Frank Was Misguided
Finally, since we're marking its 15th anniversary, let's talk about getting rid of the Dodd-Frank Act itself. It should surprise nobody that I favor getting rid of the whole thing, but Congress should at least consider amending it.
Dodd-Frank was cobbled together in the heat of the 2008 financial crisis based on the political narrative that deregulation had caused the crisis. It spawned hundreds of separate rulemakings, expanded the authority of existing federal regulators, and created new federal agencies. It imposed unnecessarily high compliance burdens, failed to solve the too-big-to-fail problem, and didn't end bailouts.
Somewhat tragically, it seems to have further cemented the notion that the federal government should plan, protect, and prop up the financial system. The Dodd-Frank Act stands not as a triumph of reform but as a case study in how sweeping legislation and regulation can miss the mark.
Banks do not want to fail, members of Congress will always want political cover for providing bailouts, and capital requirements will never guarantee financial stability. Any review of the regulatory framework should start with these facts in mind.