WASHINGTON — A Treasury Department proposal to raise capital requirements for all banks could give some large institutions an incentive to walk away from their investment banking units.
Ahead of a weekend meeting with the Group of 20 finance ministers, the Treasury released a framework for reforming domestic and international capital rules that would require set-asides for, among other activities, proprietary trading and other securities lending and borrowing that are staples of investment banking.
The plan could force large banking companies, such as Bank of America Corp., which bought Merrill Lynch & Co. on Jan. 1, to rethink keeping their investment banking units, observers said.
"That's exactly the strategic decision that would have to be made," said Karen Shaw Petrou, the managing director of Federal Financial Analytics Inc. "Is the low-cost core funding provided through a banking charter worth the far higher prudential and regulatory requirements?"
The Treasury's proposal did not specify how high the capital requirement might rise, but Petrou said it is "certainly a possibility" that capital costs would outweigh the advantages of having an in-house investment bank.
Jaret Seiberg, an analyst with Concept Capital's Washington Research Group, shared that concern. "Our worry is that there comes a time when capital requirements stop being about safety and soundness and only impede industry profitability and there's a real danger that the government may overshoot in response to this crisis and send business outside the banking industry," he said.
Others said banks could decide to keep their investment firms but seek new forms of capital arbitrage to avoid tougher requirements.
"This actually makes things worse by increasing the number of opportunities for doing end runs," said Bert Ely, an independent consultant in Alexandria, Va.
At issue is whether the Treasury's proposal could infuse new life into the so-called "shadow banking system" that has been demonized in the wake of the financial crisis. The Treasury acknowledged such concerns in its proposal.
"Stronger, higher capital requirements for banking firms will tend to increase incentives for financial intermediation to shift from the banking sector to the nonbanking sector," according to the proposal. "We must carefully guard against the emergence of systemic risk from either sector."
But observers said that would be a tall task if the standards are different for commercial and investment banks. Even investment banking leaders said this would be poor policy.
"What really bothers me here is that we cannot impose on banks more constraints than we impose on other financial institutions," said Georges Ugeux, the chairman and chief executive of Galileo Global Advisors LLC, a small New York investment firm. "What I'm concerned about at the moment is, we might be falling back into the biggest mistake we made, which was that less than 50% of the financial assets were regulated. In my view, a financial institution is a financial institution."
The Obama administration is seeking to cast a wide net over the financial industry by establishing the Federal Reserve Board as a systemic risk regulator. That way, even if B of A tried to sell Merrill, the investment bank would probably still come under the Fed's oversight. But the role of the systemic risk regulator has not been defined, leaving open the possibility that the investment bank might face lower capital requirements as a stand-alone entity than it would under the auspices of a commercial bank.
"The administration posits the capital framework in part on the grounds that systemic risk regulation would catch any nonbank," Petrou said. "But what would that mean? What would its capital requirement be? It would just be 'tough'?"
Speaking in London on Saturday, Treasury Secretary Timothy Geithner said the administration's goal is to create "a new standard that will raise capital and liquidity requirements and dampen rather than amplify future credit and asset price bubbles."
The Treasury's proposal comes as the Bank for International Settlements is plotting options that are intended to strengthen risk management at banks. A cornerstone of their proposal would emphasize the "quality" of capital by tying most of a bank's Tier 1 capital to common equity and retained earnings. "The industry is absolutely going to scream," said Kevin Jacques, the chairman of the finance department at Baldwin-Wallace College. "It's an expensive form of capital, but the fact of the matter is this crisis has shown us there's a reason why common stock is the most preferred form of equity for regulators."
The BIS also said it is developing an international leverage ratio, which could be welcome news for U.S. banks that complained for years about the competitive inequity that resulted from European institutions not following the formula.
Like the Treasury, the BIS did not release any specifics about how capital requirements would be levied, though promised to have more details by yearend and an "impact assessment" by the end of 2010.