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The Brilliant Solution to TBTF No One Is Talking About

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The debate over "too big to fail" banks is about to reignite, courtesy of the Federal Reserve Bank of New York.

On Tuesday, the New York Fed released an insightful series on how U.S. global systemically important banks received a funding advantage before Dodd-Frank and Basel III started being implemented. Moreover, one of its studies found big banks engage in riskier transactions, because they believe the government will not let them fail.

At the same time, however, the researchers found that breaking up the big banks, would hurt the economy. Unfortunately, taxpayers who have been forced to share the downsides without the upsides remain significantly exposed to the enormous credit, market and operational risks posed by TBTF banks.

For over a year, I have been analyzing bills that aim to end TBTF. In the current political environment, any bill that advocates breaking up big banks or taxing them has little chance of ever seeing the light of day. However, there is an excellent bill, H.R. 2266, that would go a long way in protecting taxpayers sitting in the office of Michael Capuano, D-Mass. It deserves to be heard by the House Committee on Financial Services.

H.R. 2266, the Subsidy Reserve Plan, would require banks over $500 billion in assets to identify on their balance sheets the portion of retained earnings that is attributable to the subsidy they receive for being TBTF. This Subsidy Reserve would count as capital for insolvency purposes but not for Basel III purposes. The reserve could not be used to pay dividends or for share buybacks. It could be monetized only in connection with the disposition of assets.

Not only would this bill make banks healthier and protect taxpayers, it would not require either political party to sacrifice its ideology. If the bill is that good, what am I missing? I took it upon myself to spend the last couple of weeks in search of different experts to talk to me about the bill.

Prof. Cornelius Hurley, Director of the Boston University Center for Finance, Law & Policy is the mastermind behind the bill. According to Hurley, the "accumulation of this reserve would incentivize TBTF banks to deleverage and to right-size themselves." This additional capital requirement could be the equivalent of Basel III's capital charge for systemically important financial institutions, but as Professor Hurley explained, ‘it would not have a cap."

Representative Capuano told me, "The idea behind my legislation is simple. If banks get a subsidy, we should quantify it and banks should hold capital sufficient to cover it. If they don’t get a subsidy, the legislation won’t have any impact on them. The process of determining the scope of the subsidy would be transparent and the Federal Reserve would write the formula. If a bank’s shareholders decide that it’s not worth holding capital in reserve to pay for the subsidy, they would be free to downsize their institution."

Notable academics support of H.R. 2266. Prof. Edward Kane of Boston College called a "very good step to measure of taxpayer stake. Taxpayers are hapless. There is no criminal punishment against banks, so they continue to take risks." The bill would also help regulators, because as Kane explained, "regulators are always outgunned by banks and playing from behind." Prof. Harvey Rosenblum, of SMU Cox and formerly at the Dallas Federal Reserve, says banks' incentives need to change. "We cannot rely on government regulators to do everything. We need to work on incentives," he emphasized. "It is a shame that H.R. 2266 cannot get a sponsor; it goes in the right direction." Rep. Capuano stated today that he is "in the process of educating my colleagues about this approach, including working to secure a Republican co-sponsor."

Rosenblum correctly pointed out that "if we look at capital ratios of community banks and those of the gargantuan ones, community banks have better ratios. There is something wrong with this picture. The exposure to the taxpayer not been legislated; this is unconstitutional." I asked him why, if H.R 2266 is a good step in the right direction, it is not moving forward? "We are embarrassed of not thinking of this first," Rosenblum said. "Even I would put myself in this camp."

Duke Law School Professor Lawrence Baxter believes it might take "another crisis before politicians move on a bill like H.R. 2266." Another milestone in the TBTF debate will be when the GAO releases part II of a study to quantify the subsidy that TBTF banks get; the first study released in November 2013 "raised questions about the appropriate scope of government safety nets for financial institutions." When the GAO releases the new study, probably in July, "banks will deny that they get a subsidy," said Baxter. "H.R. 2266 might open up a Pandora’s box about the role of government to provide subsidies to any sector of the economy."

I contacted a number of bank professional associations as well as Republicans. Either they did not respond or those that did said that they were "too busy to talk about H.R. 2266." A staffer for a leading Democrat confided that since H.R. 2266 is a moderate, nonpartisan bill, it does not motivate anyone to co-sponsor it. "It does not help us get votes."

Is this really what Washington has come to? Re-election rather than protecting taxpayers is the main priority. Certainly taxpayers deserve better.

Mayra Rodríguez Valladares is managing principal at MRV Associates, a New York-based capital markets and financial regulatory consulting and training firm. She is also a faculty member at Financial Markets World.

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Comments (13)
Rightsizing in this economy means more unemployment, does it not? We are hurting the Banks enough already. We need to be incentizing them to make mortgages., The housing industry needs to be much healthier if we are going to have a good economy. Our unemployment rate is a joke. We are hurting badly. This is not the time to create more hurt on people!
Posted by robrose | Thursday, March 27 2014 at 7:19PM ET
Excellent work. Like the proposed bill, analysis like this deserves better exposure. If anyone still thinks mortgages serve any interest other than those of the lenders, they are pretty delusional. Requiring banks to limit their risk in the fashion proposed in H.R. 2266 could serve as the first baby step toward social responsibility and ethical business conduct.
Posted by teknoscribe | Thursday, March 27 2014 at 11:01PM ET
It seems to me that the argument is based on a weak premise.

Riskier loans are not necessarily defined by ratio of impaired loans to total assets; and particularly not during the tumultuous period of 2007 - 2013.

Further, I am sure that some may find it shocking that larger Banks enjoy a funding advantage, but doesn't this simply come down to risk-based pricing. All else equal, a larger company is less risky than a smaller one. Google is less risky than a Silicon Valley start-up. a $500 billion asset size bank is less risky than a $100 million asset size bank.
Posted by Serge Milman | Optirate | Thursday, March 27 2014 at 11:16PM ET
This proposal is unworkably complicated. It makes far more sense to increase SLOWLY the leverage ratios allowed banks as they become bigger. That makes each incremental decision more important. If it requires ahigher capital ratio to be 900 billion than 800 billion, the bank will choose its business more profitably and carefully. That is the only logical solution. That also creates a more level playing field for smaller institutions not enjoying the implied guarantees. The most profitable institutions will raise capital and grow, the less profitable will see their return on equity fall and either charge more to raise their returns or cut down to the most profiable business.
Posted by pdf70101862 | Friday, March 28 2014 at 4:23PM ET
Re-election is by far the highest priority for most legislators. That's why so many ideas that are either most useful (but not necessarily popular) or most radical come from lawmakers in safe districts. Not really a surprise here.
Posted by stochastics | Friday, March 28 2014 at 5:53PM ET
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