Senators Brown and Vitter Offer a Smart and Simple Plan to End Too Big to Fail

Main St. Agenda by from American Enterprise Institute, April 25, 2013
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Banks used to have huge safety cushions, equity capital somewhere in the order of 20% to 30% of assets. Government didn’t tell them to do that. Those levels reflected what depositors and investors demanded. Then came a century of government guarantees and bailouts. Equity capital levels collapsed as banks increasingly funded themselves via borrowing. Senators Sherrod Brown, a Ohio Democrat, and David Vitter, a Louisiana Republican, want to return to the way banking used to be as a way of ending Too Big To Fail. They note that megabanks had capital ratios of about 3.5% of assets in 2007, and about 6.9% in 2012. Their plan to radically change the new and insufficient status quo:

1. The largest banks will have a minimum 15 percent capital requirement. They will be faced with a clear choice: either become smaller or raise enough equity to ensure they can weather the next crisis without a bailout.

2. Federal regulators have the option of increasing the capital level as an institution grows.

3. Capital requirements will focus on common equity and other pure, loss-absorbing forms of capital.

4. Regulators will calculate firms’ balance sheets in a more accurate way, by counting off-balance-sheet assets and obligations and considering counterparty credit risk in calculating derivatives exposures.

5. Regulators would be able to use risk-based capital as a supplement for banks over $20 billion, if their supervisory authority proves insufficient to prevent institutions from over-investing in risky assets.

Let’s not kid ourselves here; while Brown and Vitter call their legislation “The Terminating Bailouts for Taxpayer Fairness Act,” truth-in-advertising suggests it be called “The Break Up the Megabanks Act.” That is almost surely what would happen to banks with at least $500 billion in assets.

Analyst Jared Seiberg of Guggenheim Washington Research Group says the requirements “would be comparable for many mega banks to about a 25% Tier 1 Common requirement under Basel 3. Our view is that this would be a crushing capital requirement that would force the mega banks to break themselves up.”

Oh, and the bill would also kill Basel 3 and basically bar any government help to nonbank financial firms. To get to those much higher equity capital levels, commercial banks would need to take some combo of actions: Seek new equity investments, retain more earnings, limit dividends and stock repurchases, or curtail bonuses.

The megabanks will offer various reasons why these new capital requirements would be a terrible idea. Anat Admati and Martin Hellwig anticipate many of these in their book The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It. And in a paper they coauthored, the researchers spell out their responses:

Credit: Anat Admati, Peter DeMarzo, Martin F. Hellwig. Paul Pfleiderer

Credit: Anat Admati, Peter DeMarzo, Martin F. Hellwig. Paul Pfleiderer

This article was originally published by the American Enterprise Institute.