Today, U.S. Representative Ed Royce (R-CA) questioned Chair of the Federal Reserve Board of Governors Janet Yellen on bolstering the safety and soundness of the U.S. financial system through the CHOICE Act and housing finance reform during a House Financial Services Committee hearing entitled "Monetary Policy and the State of the Economy."
“We know on the one hand, that overleveraged institutions are vulnerable to market shocks. We remember the consequences. If you look back at the overleveraging of the investment banks, the large ones, 40-to-1, and if you look at the GSEs that were leveraged at that time over 100-to-1. That was in the lead up to the financial crisis. So we can see that capital standards must play a role in building resilience in the U.S. financial system. On the other hand, raising capital also has a cost to the economy and a cost in terms of what it does to the potential for growth. So what we have here is a classic cost-benefit test. There is a benefit to higher capital standards: they reduce the risk of a future financial crisis and bailouts, as well as potentially increasing tax revenues. While the costs could be borne by borrowers in the form of higher funding costs and the economy as a whole with less capital formation and a lower GDP, you’ve got that on the other side of the equation. You’ve said in the past, cost-benefit analysis is difficult work. And I agree it is not easy, but it’s not impossible and it is important. In 2010, the Basel Committee did some work on this study. Also, researchers at George Mason recently published a paper on the 'Benefits and Costs of a Higher Bank Leverage Ratio,'" said Rep. Royce.
"So how do we get to the right number? Should it be 5 percent, the 10 percent in the CHOICE Act, or 23.5 percent as proposed by the Minneapolis Fed President? There’s quite a range there, and I don’t expect you to say a number today. But can’t you agree that a cost-benefit analysis could help us more effectively [regulate] that capital?” asked Rep. Royce.
"So I do agree, that in deciding on the appropriate level of capital standards we are weighing costs and benefits. The benefit of a lower probability of a financial crisis that has incredibly high costs, against the cost of slightly higher intermediation and borrowing costs. As you indicated, Basel III was partly informed by the Basel committee’s analysis of those costs and benefits and the Federal Reserve participated in producing that analysis. I think it did inform our views of what a reasonable level of capital requirements would be. The Minneapolis Fed study that you mentioned also contains cost-benefit analysis and draws the line differently," replied Chair Yellen.
“So from my standpoint, it seems to me that the Fed would be best suited to conduct the analysis and the research on this. We have such a range of opinions, although we agree on the basic concept here. So my question would be, short of us mandating the Fed do it, would there be a way for you to try to move forward and approximate what that ratio should be?" continued Rep. Royce.
“So there are different aspects of it as I said. We did do cost-benefit analysis and it informed our judgment at the time. You’ve referred several times to a leverage requirement, and I think our understanding of the risks facing banks lead us to think that a simple leverage requirement would not be an adequate way to determine capital. In particular, a simple leverage requirement treats the risk associated with a U.S. treasury and a junk bond identically and we think that capital requirements need to be risk sensitive with a leverage ratio serving as a backup," said Chair Yellen.
"There’s another question I wanted to ask you too and that’s yesterday you told Senator Crapo that the ‘goal of bringing private capital back into the mortgage market… is important.’ And that your hope is that ‘if there are guarantees [in the secondary mortgage market], that they would be recognized and priced appropriately.’ It is my understanding then that you believe that the pre-crisis GSE model of private gains and public losses did not price the government backstop appropriately?” concluded Rep. Royce.
"I think that's correct," answered Chair Yellen.
Watch Chairman Royce's questioning here or by clicking the image below.