Higher leverage ratio is hardly a big-bank giveaway

Industry critics have charged that House Financial Committee Chairman Jeb Hensarling’s regulatory reform bill, known as the Financial Choice Act, is a big-bank giveaway. But if that were true, why do signs point to big banks turning down the gift?

In reality, Hensarling’s legislation has appeal for both those who want to unwind the Dodd-Frank Act – including Trump administration officials – and regulatory hawks who want to keep banks in check while protecting taxpayers from bailouts.

The bill should be at the center of White House efforts to make financial regulation more efficient. It gives banks a choice: either continue under Dodd-Frank regulations or, alternatively, choose to maintain higher minimum capital – by meeting a higher “leverage ratio” of 10% – in return for being exempt from many Dodd-Frank regulations that are seen as overly burdensome and micromanaging bank operations.

Andrew Harrer/Bloomberg

But the hurdle for getting that regulatory relief is high, which explains why the largest banks are expected – should the bill be enacted – to choose the status quo of Dodd-Frank. A higher “leverage ratio” means banks cannot manipulate regulatory capital with complex risk weights. All instruments are viewed the same. Essentially, this means the largest banks would need to raise boatloads of new capital to meet the new test.

The beauty of the Choice Act is it gives bankers the choice of which path to take; either way, the American taxpayers are protected. The core principle of bank regulation is to protect depositors and taxpayers from loss. Higher capital is a means toward this end. The more equity invested in a bank, the smaller the chance the bank will fail, and the less likely it could generate losses for depositors or taxpayers.

Hensarling’s bill harnesses the idea that well-capitalized bankers shun imprudent risk-taking and should be allowed more latitude to manage themselves. A well-capitalized bank should be rewarded by removing the costs of complying with a host of unnecessary safety and soundness regulations.

When a bank is required to maintain higher shareholder equity, the reduction in leverage changes its incentives. Bank managers naturally become focused on protecting their shareholders’ equity investment. A well-capitalized bank is likely to be a well-managed bank without micromanagement from bank regulators.

Industry reactions suggest that the Choice Act would be popular among community banks, but is unlikely to appeal to all banks. Large banks have even expressed appreciation for Dodd-Frank. For example, a 2013 analyst report quoted JPMorgan Chase CEO Jamie Dimon as saying some Dodd-Frank provisions expand the “moat” that gives banks like his an advantage.

That sentiment was echoed more recently by Jeremy Newell, the head of regulatory affairs and general counsel for The Clearing House Association, a trade organization for the largest, most complex banks. In testimony on the Choice Act in July, Newell said that certain Dodd-Frank provisions had fixed regulatory problems identified in the recent financial crisis, and that he supported a “pause before considering additional changes.”

The comprehensive leverage ratio is not a risk-weighted capital rule—it treats all risky assets equally. A bank mortgage loan generates the same percentage capital requirement as a startup small-business loan.

Critics argue that when equal weights apply to all bank assets, banks are encouraged to load up on risk. Their preferred alternative—the Basel risk-weighted capital measure—assigns a higher risk weight to bank assets that regulators deem to be higher-risk. While that is appealing in theory, there is no evidence that the Basel risk-weight approach is superior in practice. The Basel approach has many well-known shortcomings and indeed many believe that inaccurate Basel risk weightings were a chief cause of the subprime debacle and financial crisis.

The risk-weight critique ignores the extra capital required by the Choice Act—twice the minimum bank capital required by Dodd-Frank regulations. Moreover, without Basel’s complex regulatory risk weights, banks that opt for the higher capital test of the Choice Act cannot hide risky exposures using modeling tricks or financial engineering to make risky assets appear safer than they are.

Indeed, the Choice Act’s primary appeal is that it allows banks to choose higher capital to eliminate the need to pay legions of financial “experts” and former bank regulators to “optimize” a bank’s regulatory capital models. Bankers will be free to manage their own banks as they see fit. They can focus on lending and customer service, instead of on compliance with unnecessary complex regulatory rules.

That said Hensarling’s bill could be still improved. If the Choice Act is to be successful, it must also include comprehensive reform of the process used by bank regulators to respond to undercapitalized institutions – known as “prompt corrective action.” PCA requires regulators to intervene and even close institutions when banks are operating in an unsafe and unsound manner. The Choice Act requires the Government Accountability Office to study possible PCA reforms, but it should go further and impose a new PCA standard synchronized with Hensarling’s bill.

When a Choice Act bank falls below the 10% minimum leverage requirement, the September version of the House bill would reinstate required compliance with all Dodd-Frank rules. But imposing costly Dodd-Frank regulations on a weakened bank that can’t raise capital is only going to make consultants wealthy. The bill should be amended to include a PCA requirement for a supervisory rehabilitation plan should the capital of a Choice Act fall below a threshold set in law by Congress. The bill must also strengthen PCA bank closure rules to protect the Deposit Insurance Fund and taxpayers against future losses.

With a few minor but important adjustments, the Financial Choice Act is a regulatory solution that protects taxpayers but allows bankers to be bankers instead of compliance clerks.