Fixing Too Big to Fail?

The post-2008 regulatory crackdown continued last Friday, when a draft bill on banking reform by Senators Sherrod Brown (D-Ohio) and David Vitter (R-Lousiana) leaked. The bill aims to prevent banks—particularly the biggest banks—from ever taking another government handout. Or, if you prefer, it tries to fix “too big to fail.” Though in our view, it’s a solution in search of a problem and likely fraught with unintended consequences.

The legislation has little chance of passing in its present form—it’s pretty extreme, and even bipartisan extreme legislation tends to fizzle in a split Congress. It’s also just a draft. Messrs. Brown and Vitter could very well water it down before they drop it in the hopper. Still, the draft’s worth a look as it says much about regulators’ flawed mentality post-2008.

The provisions are fairly simple. The US would abandon Basel III and replace it with a 10% Tier-1 capital ratio, and banks with assets over $400 billion—the too-big-to-fail (TBTF) crowd—would face a 5% surcharge. Risk-weighting assets would be a thing of the past—no longer would banks be allowed to hold less capital for higher-quality assets. Instead, all assets would be equal, with US Treasurys requiring as much capital as junk CDOs or Zimbabwean sovereigns. Essentially, banking standards would rewind to the 19^th century.

This would likely wreak havoc on US banks. Losing risk-weighting would give even the healthiest a big capital shortfall, and banks likely can’t fill it by retaining earnings alone. They’d have to sell assets and/or issue equity, in many cases further diluting shares already watered down during 2008’s capital raises. Lending, needless to say, would suffer (see the UK with any questions). That means banks wouldn’t be able to help finance economic growth—their core function and a societal necessity. Big firms would be able to raise money on capital markets, but small firms and entrepreneurs would be out of luck—a recipe for economic malaise. Compounding matters, global firms could very well decide US subsidiaries simply aren’t worth the hassle, which would rob our economy of a key input.

Overall, those are big consequences for a very misguided endeavor. For one, even Brown-Vitter’s much stricter requirements don’t necessarily remove the risk of bank failures. If confidence evaporates and there’s a run, those capital buffers get depleted very quickly. Even well-capitalized banks can fail when trades go bad, and that risk could increase under Brown-Vitter, which would remove banks’ regulatory incentive to hold higher quality assets. And the government may still feel compelled to throw failing banks a lifeline if officials think it’s necessary to prevent outright panic in the financial system.

The laser focus on TBTF is also off the mark. Consider 2008’s bank failures. The biggest, WaMu, had $307 billion in assets and $188 billion in deposits—well under Brown-Vitter’s TBTF threshold. IndyMac—the first failing regional bank to make headlines—had $23.5 billion in assets and $6.4 billion in deposits (and about half that when it failed). GMAC had $189.5 billion in assets, but the bank arm had $32.9 billion in assets and $17.7 billion in deposits. Of these institutions, only GMAC was bailed out (nationalized)—the others were bought out. Overall, between 2008 and 2010, 322 banks failed, with a total of around $630 billion in assets. WaMu accounted for about half that. Most banks that went under were teensy.

The TBTF crowd, by contrast, largely pulled through. Yes, some had funding squeezes and balance sheet troubles, but those that needed capital raised it from shareholders—something they were able to do because of their size. Size also helped these banks ride to the rescue in 2008 by buying failed banks’ assets and liabilities—Wachovia, WaMu and others were absorbed by TBTFs. Some might quibble about TARP assistance, but TARP was designed to try to fill the hole mark-to-market accounting created. That was a regulatory issue, not a size issue, and the funds were foisted upon institutions regardless of whether or not they needed the funds. Today, the TBTFs have pretty healthy balance sheets. The six exceeding Brown-Vitter’s threshold have Tier-1 capital ranging from 11.75% to 17.9% as of their latest filings. That’s well in excess of Basel standards and where banks were pre-2008. Banks are already making every effort to prevent themselves from going belly up. (Amazingly, when left to their own devices, banks want to do what it takes to be a long-term going concern.)

Some argue the problem isn’t just that banks are too big to fail, but that they’re too big to jail—that, as Attorney General Eric Holder told Congress last month, if the government prosecuted their allegedly criminal behavior, the economic fallout would be too great. Yet Holder offered no specifics, and there’s no evidence the government has passed on prosecuting any US bank due to its size. If they have passed on prosecutions, that’s likely more a political choice than an economic one. There’s no evidence prosecuting has automatic economic consequences. UK banks are mired in legal proceedings for the LIBOR scandal, and some have already paid the piper, but economic Armageddon hasn’t ensued.

As we’ve said before, we’re not anti-regulation—the industry needs oversight to ensure transparency and foster prudent management. And TBTF banks may indeed be a greater systemic risk. But by trying to fix that, politicians likely end up doing more harm than the big banks they so fear—which also do quite a bit of good by using their economies of scale to underwrite the largest loans and projects. Perhaps a better fix would be to foster competition from smaller banks—create a more flexible system that allows challengers to flourish and grow and give the big boys a run for their money. And to enable that, instead of overreaching like they have since 2008, perhaps our politicians should steal a page from the late Margaret Thatcher’s playbook and bring back the Big Bang.