New Capital Requirements Would Make Big Banks More Responsible For Their Investments

Many in Washington are desperate to find a way to safeguard the economy from the recklessness of the “too big to fail" banks.
By @FrederickReese |
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    The Great Recession, which was caused by the largest financial collapse since the Great Depression, has left many in Washington and elsewhere desperate to find a solution that will protect the economy from the recklessness of the “too big to fail” banks. On Monday, the Federal Reserve Board, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency moved to impose new restrictions on the nation’s largest banks.

    Under the proposed rule, the eight largest bank holding companies — including Bank of America Corp., JPMorgan Chase, Citigroup, Wells Fargo, Goldman Sachs and Morgan Stanley — will be required to hold a minimum of an additional 2 percent of their total assets in reserve, along with the 3 percent already mandated for all banks. Failure to comply will result in penalties against discretionary bonus payments and capital distributions. In addition, the rule would require the FDIC-insured banks owned by the “Big Eight” to meet a 6 percent leverage ratio to be considered “well capitalized.”

    “A perception continues to persist in the markets that some companies remain ‘too big to fail,’ posing an ongoing threat to the financial system,” the interagency notice read. “First, the existence of the ‘too-big-to-fail’ problem reduces the incentives of shareholders, creditors and counterparties of these companies to discipline excessive risk-taking by the companies. Second, it produces competitive distortions because companies perceived as “too big to fail” can often fund themselves at a lower cost than other companies. This distortion is unfair to smaller companies, damaging to fair competition, and tends to artificially encourage further consolidation and concentration in the financial system.”



    This is seen as a protective measure for the FDIC. Leverage is the ratio of borrowed capital to “cash in hand” — or the physical assets available to secure the borrowed assets. So, for example, $100 borrowed on $5 has a leverage of 20 to 1. So, in practical terms, if a bank has $100 billion in physical assets, under the mandated 3 percent reserve requirement, the bank can borrow up to $3.33 trillion.

    The normal ebb and flow of banking dictates that banks could lose money on their investments, just as they can earn money. As long as the bank does not lose its “cash in hand” — also known as a cash reserve — the bank can theoretically raise enough capital to meet its losses. A bank’s leverage ratio is the relationship between the bank’s assets — borrowed or actual — and its core capital, or “cash in hand.” However, if a bank loses its “cash in hand,” the bank will default on its borrowing — as it no longer has sufficient collateral. In such a case, the bank will have to settle its debts in order of seniority, with consumer assets last in line. Since consumer assets in FDIC-insured banks are guaranteed by the FDIC, this would put the government on the line to bail out the bank.

    On top of this, banks have the ability to designate what assets will be used to determine the bank’s risk, or potential for loss. For example, a bank can say that only its depository accounts bear risk, while their bond portfolio does not. This is known as risk-weighting.

    This is what caused the Great Recession. A glut of sub-prime mortgage defaults and the swapping of derivatives drawn on these defaults overextended many banks that used creative methods to calculate their assets so that they could minimize their mandated cash reserve. This left many banks with neither the collateral to raise the capital to cover their losses nor the reserve to cover consumer accounts. As a result, $467 billion was allocated via the Troubled Asset Relief Program to prevent the largest banks in the U.S. from collapsing, dragging the American economy down with them.

    “Over time, the government’s safety net of deposit insurance, Federal Reserve lending and direct investment has been expanded to an ever-broader array of activities outside the historic role of commercial banks — transforming short-term deposits into long-term loans and operating the payments system that transfers money around the country and the world,” said Thomas Hoenig, the director of the FDIC, in a hearing before the House Committee on Financial Services. “In the U.S., the Gramm-Leach-Bliley Act allowed commercial banks to engage in a host of broker-dealer activities, including proprietary trading, derivatives and swaps activities — all within the federal safety net. Following passage of this Act, in order to compete with subsidized firms, broker-dealers found it necessary to either merge with commercial banks or change their business model by taking on dramatically greater debt and risk… Institutions engaged in banking activities significantly contributed to the crisis whether they were called ‘banks’ at the time or not.”

    “Even today, following enactment of the Dodd-Frank Act, government support of these dominant firms, explicit and implied, combined with their outsized impact on the broader economy, gives them important advantages and encourages them to take on ever-greater degrees of risk,” Hoenig continued. “Short-term depositors and creditors continue to look to governments to assure repayment rather than to the strength of the firms’ balance sheets and capital. As a result, these companies are able to borrow more at lower costs than they otherwise could, and thus they are able increase their leverage far beyond what the market would otherwise permit.”


    Basel III and bank autonomy

    The new interagency proposal is based in part on recommendations by the Basel Committee on Banking Supervision, which recognized that loss absorbency of the world’s systemically important banks must be increased — with the threat of even greater increases to dissuade the banks from expanding their economic impact. The Basel Committee has also recognized that the model of evaluations the various banks use to measure their risk-weighted assets are vastly different, making meaningful across-the-board evaluations almost impossible and meaningless. The FDIC has argued that the banks’ ability to internally “tweak” their risk endangers the American economy. The Basel Committee’s research showed that some banks are holding as much as 40 percent less in reserves than comparable banks.

    On Monday, the Basel Committee for the first time introduced the consideration of doing away with internal risk modeling in a paper that also called for discussions to limit national discretion and switch from risk-weighted capital ratios to non-risk-weighted ratios.

    “The committee is keenly aware of the current debate concerning the complexity of the current regulatory framework… The paper being released today is designed to encourage discussion among, and solicit views from, a broad set of stakeholders,” said Stefan Ingves, chairman of the committee.

    Currently, the global banking community adheres to Basel III, or the Third Basel Accord, which is a voluntary accord that was intended to introduce a leverage ratio at a minimum of 3 percent of assets and 6 percent for the largest banks. Many of the large banks have fallen below these standards when measured objectively, as many banks measure risk conservatively.

    The public has 60 days to comment on the proposed new interagency rules, which will then have to be approved by regulators. The new rules have an effective date of Jan. 1, 2018.

    “I support more and better capital,” Hoenig said at Tuesday’s FDIC board meeting. “However, the Basel 3 standard, without a binding leverage constraint, remains inadequate to the task of assuring the American public, who paid a high price for the financial crisis, that our capital standards are adequate to contribute to financial stability.”

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