If bank capital has to be higher, let's regulate nonbanks

Bloomberg News

I'd like to take you back to a simpler time — to 2016. 

Back then, the Republican and Democratic primaries were both contested, and candidates were throwing policy ideas out there to see what gained traction. One of those, at least on the Democratic side, was the question of whether and how to break up the country's largest banks. Since those banks had been a very big part of a cascading failure that had very recently pushed the country into the worst financial crisis in generations, there was some political urgency to the question of whether those institutions ought to continue to exist in their present form.

Into that policy scuffle stepped Neel Kashkari, the erstwhile Republican candidate for Governor of California who had recently been named President of the Federal Reserve Bank of Minneapolis. In a speech that February at the Brookings Institution, Kashkari plowed head-on into the debate, declaring that Dodd-Frank had not solved the problem of Too Big To Fail, and that policymakers should instead embrace a more radical approach that would either compel banks to break themselves up into less systemically risky pieces or become "public utilities" stuffed with, as he put it, "so much capital that they virtually can't fail."

That vision was ultimately consummated several months later in something called the Minneapolis Plan, which, among other things, would raise risk-weighted capital minimums for banks with more than $250 billion to 23.5% — up from the then-minimum of 13% — and require the Treasury Secretary to certify that those banks are not Too Big To Fail, raising capital beyond that minimum until they can be so certified, up to 38% risk weighted capital.

Fast forward to today, a time when the question of how high bank capital ought to be is still very much alive, albeit in a slightly different form. The Federal Reserve, Federal Deposit Insurance Corp. and Office of the Comptroller of the Currency issued a bank capital proposal, known as Basel III endgame, which ostensibly adjusts risk weighting of a bank's assets and methodologies of ascertaining capital, but in effect would raise capital on the largest banks by between 16% and 30%, depending on who you ask. 

Comparing the Minneapolis Plan to Basel III endgame is like comparing apples to tubas, not least because between 2016 and last year the Fed's process for determining risk-weighted capital minimums has evolved to rely on the stress capital buffer as a key ingredient, meaning that the minimum is different from bank to bank based on how well its portfolio performed in the prior cycle's stress test. But even the most expansive estimates of the capital impact of Basel III endgame wouldn't come close to the lowest risk-weighted requirements under the Minneapolis Plan. 

But there's another difference between the Minneapolis Plan and Basel III endgame, and that is that the Minneapolis Plan included a separate prong that would impose a tax on nonbank financial companies — including hedge funds, mutual funds and nonbank intermediaries — of between 1.2% and 2.2%, depending on systemic risk. 

"We acknowledge that a byproduct of imposing higher capital requirements onto banks may be the migration of risky activity from the banking sector to nonbank financial firms, where capital requirements are lower, if they exist at all," the plan said. The nonbank tax "would effectively make the cost of funds roughly equivalent between large banks and nonbanks."

Again, these two proposals aren't shooting at the same target, so pointing out that no such nonbank dimension exists in the Basel III proposal isn't fair. But they are comparable in so far as they are both contemplating where bank capital ought to be, and if the Minneapolis Plan at least acknowledged the potential for higher bank capital to push activities outside the banking perimeter, some similar acknowledgement should be made in the form of a concrete vision for the nonbank financial sphere if bank capital is going to increase in a meaningful way, even if it isn't precisely as outlined in the proposal.

Federal Reserve Vice Chair for Supervision Michael Barr did acknowledge the growth of nonbank intermediation in a December 2022 speech at the American Enterprise Institute, saying that nonbanks "fund nearly 60% of the credit to the U.S. economy today, as compared to approximately 30% in 1980." But the solution ought not to be lowering bank capital to make it align with nonbanks, he said. 

"We should monitor the migration of activities from banks to the nonbank sector carefully, but we shouldn't lower bank capital requirements in a race to the bottom," Barr said. "In times of stress, banks serve as central sources of strength to the economy, and they need capital to do so."

Fair enough. But if a level playing field between banks and nonbanks is a desirable policy outcome and bank capital shouldn't go down, then there should be some kind of a vision of making nonbanks' lending inputs look more like those of banks. 

The appropriate venue for such a vision is the Financial Stability Oversight Council, and they are steadily putting one foot in front of the other, having rescinded a Trump-era guidance concerning the systemic risk designation process for nonbanks late last year. But the more important question is how the council would designate activities rather than institutions as systemically risky — a proposition that has never been tried.

But try they must, because the entire idea that higher bank capital makes the financial system safer rests on the assumption that U.S. commerce runs through the banking system. Otherwise, we're back to where we were in 2016 — or, really, 2008. That's not a plan anyone should get behind.