The biggest banks have done an excellent job of delaying and undermining the Dodd-Frank financial overhaul law and staving off criminal investigations into wrongdoing.
Maybe, just maybe, they’ve been too successful.
If the bankers who blew up the financial world had been held accountable, the popular fury that fuels this bill would have dissipated by now. And if Dodd-Frank were fully in place today, instead of being bogged down in the courts and in the halls of Washington regulatory offices, there would be no political momentum behind such an effort.
Now, we will see whether the bill is simply a barbaric yawp of anger at the big banks or something with actual force. It probably won’t get passed, but its underlying premise cannot be dislodged from the Washington conversation.
The Brown-Vitter bill calls for the banks with more than $500 billion in assets — I’m looking at you JPMorgan Chase, Citigroup, Bank of America, Wells Fargo, Goldman Sachs and Morgan Stanley — to have capital reserves of 15 percent. That’s a much higher standard than exists today, especially because the current requirements have weak definitions of capital and total asset size.
The banks have rounded up a bunch of critics, led by the likes of the law firm Davis Polk & Wardwell and the lobbying firm Hamilton Place Strategies, the volume of their lamentations likely in direct proportion to the hourly rate they bill their clients. They invoke terrifying, talismanic statements: The bill is a “punishment” to big banks. It is simplistic, impossible, will render American banks “uncompetitive,” lead to financial crises and probably cause tooth decay.
This naïve bill would force the giant banks to raise too much capital and would hurt the economy as the companies were forced to shrink or break up. Standard & Poor’s is one of the observers warning of a financial crisis. And who better to know than the people who brought us the last one?
Goldman Sachs and S&P estimate the big banks might be forced to raise $1 trillion or more. That’s a lot, so much that the leviathans’ agents cry out that they couldn’t sell that much stock. But they don’t have to raise it all at once. And they can retain their earnings and stop paying dividends in addition to selling shares.
In putting that argument forward, they don’t realize they make Senators Brown and Vitter’s case for them. If investors are so terrified of the big banks that they won’t buy their stock, that’s a terrific problem. Most of the big banks trade below their net worth, an indication that investors don’t trust them. Brown-Vitter might actually help banks by restoring that trust.
The Brown-Vitter bill serves as a good time to remind defenders of big banks what bank “capital” is. As Professors Anat Admati and Martin Hellwig have pointed out in their indispensable book “The Bankers’ New Clothes,” capital is not a rainy-day fund. It’s not stored away in a vault somewhere, never to be touched. Capital — the rest of us know it as “equity,” like the down payment on a house — is simply money that absorbs losses. The more money a bank raises from shareholders, the more profit it keeps on hand, the less it has to borrow and the more solid it is. The bank can still lend that money. And if JPMorgan Chase doesn’t lend to some small business, perhaps a regional or community bank will.
There might be some trade-offs to higher capital requirements, but we know there are costs to lower ones: financial crises. Some try to argue that the banks faced a liquidity crisis in 2008, what we call a run on the bank. Yes, that was true in the autumn of 2008. But the crisis didn’t start then. It started in the late summer of 2007. If the banks had been more solidly capitalized, there would have been fewer panicked investors.
Banks desire as little capital as they can get away with. It’s easier to make higher returns on equity with greater debt. Often management is paid in stock. But society as a whole doesn’t benefit from banks that are running with too much leverage. They collapse.
So, it is better to have higher equity capital. But Brown-Vitter doesn’t go far enough. The bill’s definition of equity could be tighter. It still contains bookkeeping entries called intangible assets and deferred tax assets, which don’t absorb losses.
But, gratifyingly, Brown-Vitter does tighten up the definition of assets. Capital is the numerator and assets are the denominator. Both need to be made as solid and trustworthy — and resistant to manipulation by banks or regulatory capture — as they can be. When calculating assets, Brown-Vitter tightens up rules on things like how the banks measure their exposure to derivatives.
Oh, the critics shout, this is just a backdoor way of making banks smaller. The bill’s authors fail to understand that diversity of exposure saves gargantuan banks, they say. This requires a slap to the side of the head and a one-word rebuttal: Citigroup. Citi blew up because of its exposure to collateralized debt obligations. That exposure was dismissed and misunderstood by the top ranks because it was seemingly small as a portion of the bank’s balance sheet. It was wonderfully diversified into all kinds of investments, which didn’t help at all. Sure, small banks are less diverse. But when they collapse, the problem is more manageable.
Brown-Vitter inhibits regulators from using risk-weighting of assets, where banks and regulators determine which kinds of investments are safe and require little capital behind them. Davis Polk declared that getting rid of risk-weighting is “too blunt,” somehow immune to the absurd spectacle of lawyers opining on proper risk management.
In fact, risk-weighting has a storied history of blunder. Residential mortgages and sovereign debt, like that of, say, Greece, were once viewed as carrying little risk. Risk-weighting encourages banks to crowd into assets thought to be safe, in that way making them unsafe. It lulls them, and regulators, into a false sense of confidence. Perhaps throwing out risk-weighting might lead lots of banks to buy stuff that is known to carry risk. It’s far better to have them piling into investments that are known to be risky and count those purchases with a clearer, less manipulated number. Then, regulators need to pay attention, which, call me crazy, is their job.
Brown-Vitter also ties regulators’ hands on whether they can pour taxpayer money into failing banks. Here, it’s less plausible. Dodd-Frank has given regulators resolution authority, which gives them the power to unwind failing institutions and impose losses on the shareholders and creditors. Brown-Vitter tries to eliminate what Dodd-Frank skeptics see as too much regulatory flexibility.
It’s a noble idea. But the problem, as Paul A. Volcker has pointed out, is that if JPMorgan Chase is truly failing, it’s almost a certainty that Citi and Bank of America are going down, too. And taxpayers would then have to step in in some fashion.
So, taxpayers are implicitly on the hook for the financial sector, even with Brown-Vitter.
That’s why we need the biggest banks to have truly clear and understandable balance sheet fortresses.