Re-posting, updating thread on the Fed’s approach to bank capital.

Please know my tremendous respect for the Fed and Chairman Powell. But I am baffled by his comments yesterday on bank capital. There are two ways to expand banks’ lending capacity: increase their capital base or increase their leverage.

Increasing the capital base has the obvious advantage of expanding lending capacity without sacrificing financial integrity. The easiest way for banks to do this is by retaining their earnings instead of paying out cash to shareholders and executives.

Increasing leverage (by reducing capital requirements) will also expand lending capacity, but that also weakens a bank’s capital position and thus increases the risk of a bank failure. Unfortunately, this has been the Fed’s preferred approach.

Chairman Powell has defended this approach because he says US banks are “highly capitalized”. If that is so, one wonders why the Fed has found it so urgently necessary to give them relief from current capital rules.

For instance, the Fed recently gave relief from the “supplemental leverage ratio” -a bare bones backstop to keep banks from taking on dangerous levels of leverage. It requires a mere 3% of equity financing (33/1 leverage) for most and 5% (19/1 leverage) for the biggest.

These are very high levels of leverage but they are calibrated based on the assumption that banks’ assets (the denominator in the ratio) will include low risk assets like US Treasuries and reserve deposits, as well as risky assets like leveraged loans or uncleared derivatives.

But the Fed has taken those low risk assets out of the denominator leaving the riskier ones where 3%/5% is a very slim margin to ensure continued bank solvency, particularly given current stressed conditions. The other regulators have not gone along so far.

This risk could be mitigated if the Fed simply told systemic banks to retain their capital, including the suspension of cash dividends and discretionary bonuses, until the crisis passes. Why the Fed refuse to do so remains a mystery.