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Editor at Large

Why We Don't Need Brown-Vitter — Yet

Patience is among the many virtues lacking in politics.

The consensus in Washington is that "more needs to be done" to end "too big to fail," but the bulk of the reforms Congress and the Basel Committee adopted in the wake of the 2008 crisis have yet to be adopted. So no one truly knows if we've done "enough" yet.

Will proposed counterparty limits reduce interconnectivity among the giant firms and in turn cure contagion risks? Will higher, stronger capital requirements lead the largest banks to shrink? Will living wills work? Will regulators have the backbone to take over and unwind a big firm that gets into trouble?

I could go on, but every major question about the safety and soundness of the financial system is addressed in either the Dodd-Frank Act of 2010 or the Basel III rules agreed to by international regulators on the Basel Committee that year.

We just don't know yet whether the answers will be effective, and that's where impatience comes in.

Sens. Sherrod Brown, D-Ohio, and David Vitter, R-La., jumped into the "do more" breach last week with their bill to crank up the equity capital ratio on the largest banks to 15% of assets.

The lawmakers want to make the system safer and figure the more capital, the better.

But is it? I don't know, and neither do Brown and Vitter.

Neither has explained how their Terminating Bailouts for Taxpayer Fairness Act will affect the largest banks, the industry or the economy. Is 15% the right level? Is $500 billion the right size? Will lending crater? Will economic growth suffer?

Let's assume the legislation is enacted as written and the largest banks all decide to break themselves up to get below the $500 billion asset threshold to qualify for a lower capital requirement of 8%. That would make the largest bank in the U.S. the 51st largest in the world, just ahead of Banque Federative du Credit Mutuel in France.

It would also mean those six giant firms turned into 21 companies.

How would these smaller U.S. banks compete with foreign rivals that get to hold half as much capital? Would foreign government retaliate if the U.S. pulls out of Basel III? Would the U.S. still be the center of global finance?

We need to consider these questions and the repercussions of the answers.

Brown and Vitter have presented no analysis of the costs and benefits of their bill and haven't yet made a convincing case that adopting this legislation will improve our financial system.

That may be why so few lawmakers or regulators are embracing it. About the only enthusiastic support has come from the Independent Community Bankers of America. "It's time to put capital back into capitalism," ICBA president Cam Fine says.

And capital is at the heart of Brown-Vitter. Financial firms with assets of more than $500 billion would have to hold 15% of assets as tangible equity capital. Banks with $50 billion to $500 billion would have to meet an 8% ratio.

The bill's impact would be magnified by the fact that it would expand what's considered an asset by including some off-balance-sheet assets and uncollateralized derivatives.

Brown-Vitter takes another step beyond the 15% and the broader definition of asset, requiring a "surcharge" to offset "any distortion of capital levels" resulting from federal government programs like deposit insurance.

Duke law professor Lawrence Baxter considers himself "generally sympathetic" to the Brown-Vitter legislation, but says in an email that he's "far from convinced" it's the right approach.

Baxter agrees that it seems the senators haven't thought through the ramifications "of this enormous diversion of investment from other sectors, or of the substitution of (expensive) capital for (cheap) debt.

"Appealing as a requirement for much higher levels of capital might seem," Baxter writes, "the changes in economic dynamics that a capital-based restructuring of the banking industry might entail ranging from redeployment of capital from other industries to credit migration into the shadow banking sector are not yet understood. These changes might well prove counterproductive, so it is at the very least premature to leap to such a solution."

It's hard to figure out just how much more capital the largest banks would need. Goldman Sachs has estimated the biggest banks would need to raise $908 billion in new equity while the next-tier banks would need an extra $145 billion. That squares nicely with the $1.2 trillion estimate S&P gave for all banks.

Critics dismiss these reports as little more than biased industry spin.

But Keefe, Bruyette & Woods took a crack at estimating the megabanks' capital ratios under Brown-Vitter and the results are, to quote one of the report's authors, "pretty eye-opening." Morgan Stanley's capital would have to nearly quadruple its current capital levels to meet the new standard. Even Wells Fargo, which came out the winner in the KBW report, would face a hefty capital raise. On average, "You'd have to triple the capital levels of the biggest six banks," Fred Cannon, KBW's director of U.S. research, says in an interview. "They'd have to go out to the market and raise a lot of capital or they would have to break up."

Asked how much capital these banks would have to raise, Cannon chose a descriptive word over a number: "a boatload."

Before you write Cannon off as a defender of big banks, read on.

"There is no evidence to show that this would necessarily curtail lending and send the economy into a tailspin," Cannon says.

In contrast, Goldman says Brown-Vitter would "remove an estimated $3.8 trillion in lending capacity from the U.S. banking system, or 25% of today's levels."

Cannon says higher capital can lead to less lending, but it doesn't have to. It all depends on the choices individual banks make. Some banks may choose to shrink assets, including loans, to reach the stricter capital ratios, but others won't. "It can be argued both sides, and I don't think the evidence is all that clear on either side," Cannon says.

What's more, Cannon agrees with the main goal of senators' legislation: cutting the giants down to size. "A transition to smaller, safer institutions would be probably the best outcome for the U.S. economy over time," he says.

But, Cannon adds, "It would be best to let the market figure those things out rather than have it be dictated from Washington."

That brings me back to patience.

The senators ought to turn up the pressure on regulators to get crucial Dodd-Frank reforms in place. Then policymakers can see where we actually do need "more."

If policymakers decide more action is needed, then let's raise capital levels at a manageable pace, such as half a percent at a time. Fed Gov. Jeremy Stein called for such a "turning-up-the-dials approach" last month.

That approach makes more sense and it would be easier to find the balance between enough capital and too much.


(9) Comments



Comments (9)
The risks posed by the status quo are enormous. In comparison, the risks posed by Brown-Vitter are minuscule. Why wait to see if the Apocalypse happens?

Moreover, the damage imposed on the real economy NOW by the big banks and their paper economy are substantial. We need to discourage their reckless gambling, which sucks money out of the real economy.

Equally important, we need to break up the big banks to weaken their political power. Even Stein, in his April 17, 2013 speech, acknowledges,"Of course, I recognize that its gradualist nature presents practical challenges, not least of which is sustaining a level of regulatory commitment and resolve sufficient to keep the dials turning so long as this is the right thing to do."

Given the ability of a few big banks to "capture" regulators, that caveat is decisive.

And Stein acknowledges, "Numerous studies across a wide range of industries have documented how difficult it is for managers to voluntarily downsize their firms, even when the stock market is sending a clear signal that downsizing would be in the interests of outside shareholders."

Of course. Their salaries, bonuses, and fees depend on being big, opaque, and interconnected. Barbara, the faith that you and Stein place in regulators is unwarranted. We the people and our elected representatives must enact legislation to make banks do banking, clearly and simply, like Munger recently stated.
Posted by Reform-Wall-Street.org | Thursday, May 09 2013 at 7:13PM ET
Barbara is asking us to be patient... says we should wait and see if Basel III and Dodd-Frank will work to end TBTF as they have not been fully implimented. I would simply ask Barbara if she remembers how many times Citibank has been bailed out by the government? How many
"fail safe" laws and rules were written each time to prevent it from happening again? I think we've been patient enough. Read these words slowly and carefully if necessary, Barbara.... Too Big To Fail.
Posted by TxTim | Monday, May 06 2013 at 10:06AM ET
Most Basel specialists, regulators and legislators agree that Basel will be destructive to the thousands of small community banks under $500 million and the communities they serve. Most agree that the Basel structure was never intended for these small financial institutions. So why can't we get anyone to sponsor a bill that represents only Community Bank Reforms, including QM, without all the entanglements of TBTF?
Posted by Small Bank President | Friday, May 03 2013 at 3:04PM ET
"Yet" is a scary word. Can we afford to get it wrong twice? The last financial crisis was nearly fatal and the TBTF banks are even bigger today.
Posted by tjorde | Thursday, May 02 2013 at 4:54PM ET
"...the bulk of the reforms Congress and the Basel Committee adopted in the wake of the 2008 crisis have yet to be adopted. So no one truly knows if we've done 'enough' yet." The fact that the rule-making is proceeding so tentatively and inserting lots of exemptions and loopholes tells us a great deal. Asking you and me to wait to see whether the post-DFA and Basel III rule-making will produce the quality of supervision a healthy financial system needs is asking us to play the fool again.
Posted by Edward Kane | Thursday, May 02 2013 at 12:44PM ET
Wayne, Brown/Vitter isn't about resolving failed banks. If Brown/Vitter had been in effect these banks you mention would have had the resources to fail responsibly without risk to the taxpaying public. The marketplace functioned properly, nobody wanted any part of these mega banks and that was reflected in their inability to sell enough stock to raise enough capital. So, the US government put a gun to the heads of taxpayers and forced them to invest in these risk taking, irresponsible behemoths! Frankly, it pissed me off. I had to invest in my competitor, even though I didn't want to and then had to essentially compete against the government. All the while, my and the three generations of my family before me behaved responsibly.

Not all banks have gotten bigger, in fact the majority of size increase is limited to the top 50 or so banks in this country. and, along the way they got a pass on several federal laws designed to prevent over concentration that the rest of the industry continued to be required to comply with.

You are missing the point of TBTF and the attendant risks to our economy and the taxpayers.
Posted by grsb | Thursday, May 02 2013 at 12:15PM ET
And why have the big banks gotten bigger? By and large by acquiring failed banks. And where would we have found banks to handle the failures of Wachovia and WaMu with so little disruption if Brown-Vitter had already been the law? It is also worth noting that banks of all sizes have gotten much bigger since the recession (some of them much, much bigger than they were), for much the same reason, by being the means for the orderly resolution of failed banks. Now if you just prefer courthouse auction as the method for resolving failed banks, then maybe we don't need to have healthy banks acquiring failed banks, and growing bigger in the process. That would probably not be healthy for the economy nor of much help to bank customers. Nonbank competitors of banks might like it, though.
Posted by WayneAbernathy | Thursday, May 02 2013 at 12:05PM ET
I couldn't agree more with grsb.The large banks have only gotten bigger since the crisis. They are beyond anyone's control or ability to manage the risk. $2.4 trillion is too powerful and too big to be allowed to operate with taxpayer's money. Government intervention into the size of companies is not unprecedented. That is why we have Anti-trust laws. If there ever was a situation involving "anti-trust", it is with the large banks. I don't trust them or the government to regulate them!
Posted by GeorgeBailey | Thursday, May 02 2013 at 10:12AM ET
Ms. Rehm, at it again; defending the biggest of the big, and always in the most veiled way. The Brown/Vitter bill is a significant step in the right direction to ending the TBTF reality that our country is saddled with. S.798 effectively does little more than require the biggest to gamble with their own money, rather than todays standard where they gamble with the taxpayers money.

I am a fourth generation community banker. When I unlock my bank's door in the morning I know that whatever risk decision are made during that day are being made with my personal capital. Banking is about risk management, not taking excessive risks and certainly not about hiding those risks in tricky, often deceptive off balance sheet products and companies. The biggest banks are not properly capitalized, and they cannot support the excessive risk taking they engage in on their own, they NEED the taxpayers as a back stop and that violates every principle that this country and our economy was founded on.

Brown/Vitter does not require the mega banks to break up. It requires them to pay their own freight and to cover their risk taking without putting the taxpayers in harms way, again!

Dodd/Frank and the BASEL III proposals do not have any features that get to the core of the issue the way that S.798 does so waiting will do nothing more than prolong the status quo. The tax payers of this country should all be mad as hell and demand more from our members of congress, and presently should be demanding that S.798 be voted on and passed immediately and that a House version of the bill have the same action taken so it can be signed into law this summer.
Posted by grsb | Thursday, May 02 2013 at 9:32AM ET
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