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

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.