August 11, 2022

Economix: The Big Banks Fight On

Today's Economist

Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

The bank lobbyists have a problem. Last week, they lost a major battle on Capitol Hill, when Congress was not persuaded to suspend implementation of the new cap on debit card fees. Despite the combined efforts of big and small banks, the proposal attracted only 54 votes of the 60 needed in the Senate.

On debit cards, the retail lobby proved a surprisingly effective counterweight to the financial sector. On the next big issue — capital standards — the bankers have a different problem: this highly technical issue is more within the purview of regulators than legislators and is harder to develop a crusade about, as it’s widely regarded as boring.

As the bankers busily rallied their forces to fight on debit cards and spent a great deal of time lobbying on Capitol Hill, they were doused with a bucket of cold water by Daniel K. Tarullo, a governor of the Federal Reserve.

In a speech on June 3, Mr. Tarullo implied capital requirements for systemically important financial institutions — a category specified in the sweeping overhaul of financial regulation last year — could be as high as 14 percent, or roughly double what is required for all banks under the Basel III agreement.

Whether the Federal Reserve will go that far is not certain; a capital requirement of an additional 3 percent of equity (on top of Basel’s 7 percent) may be more likely, but that is still 3 percent more than big banks were hoping for. (These percentages are relative to risk-weighted assets.)

The big banks are likely to mount four main arguments as they press their case against the additional capital requirements, Reuters has reported:

1. “Holding capital hostage” will hurt the struggling economy because it will mean fewer loans at a time when lending is already depressed.

2. Establishing “huge” capital buffers is an admission by regulators that last year’s Dodd-Frank financial overhaul does not accomplish its goal of reducing risk.

3. If banks hold onto more capital and make fewer loans, borrowers will turn to the “shadow banking sector” – the so-called special purpose vehicles, for example — which has little or no oversight.

4. Tough standards in the United States would create a competitive disadvantage vis à vis other countries.

Each of the bankers’ arguments is wrong in interesting and informative ways.

First, capital requirements do not hold anyone or anything hostage — they merely require financial institutions to fund themselves more with equity relative to debt. Capital requirements are a restriction on the liability side of the balance sheet — they have nothing to do with the asset side (in what you invest or to whom you lend).

There is a great deal of confusion about this on Capitol Hill, and whenever bankers (or anyone else) talk about holding capital hostage, they reinforce this confusion. This is not about holding anything; it is about funding relatively less with debt and more with loss-absorbing equity. More equity means the banks can absorb more losses before they turn to the taxpayer for help. This is a good thing.

The idea that higher capital requirements will increase costs for banks or cause their balance sheets to shrink or otherwise contract credit is a hoax — and one that has been thoroughly debunked by Anat Admati and her colleagues (as this now-standard reference, which everyone in the banking debate has read, shows us).

Professor Admati is taken very seriously in top policy circles. (Let me note, too, that she is a member of the Federal Deposit Insurance Corporation’s Systemic Resolution Advisory Committee, an unpaid group of 18 experts that meets for the first time next week; I am also a member.)

In a recent public letter to the board of JPMorgan Chase, whose chief executive, Jamie Dimon, is an opponent of higher capital requirements, Professor Admati points out that these requirements would — on top of all the social benefits — be in the interests of his shareholders. The bankers cannot win this argument on its intellectual merits.

The second argument, that establishing “huge” capital buffers is an admission by regulators that last year’s Dodd-Frank financial overhaul does not accomplish its goal of reducing risk, is an attempt to rewrite history.

During the Dodd-Frank debates last year, the Treasury Department and leading voices on Capitol Hill — including bank lobbyists — said it would be a bad idea for Congress to legislate capital requirements and should leave them to be set by regulators after the Basel III negotiations were complete.

Now the time has come to do so, and Mr. Tarullo is the relevant official — he is in charge of this issue within the Federal Reserve and is one of the world’s leading experts on capital requirements.

But the banks now want to say that this is not his job as authorized by Dodd-Frank. This argument will impress only lawmakers looking for any excuse to help the big banks.

The third bankers’ argument, that borrowers will turn to the “shadow banking sector,” contains an important point — but not what the bankers want you to focus on.

The “shadow banking sector” — special purpose vehicles, for example — grew rapidly in large part because it was a popular way for very big banks to evade existing capital requirements before 2008, even though those standards were very low.

They created various kinds of off-balance-sheet entities financed with little equity and a great deal of debt, and they convinced rating agencies and regulators that these were safe structures. Many such funds collapsed in the face of losses on their housing-related assets, which turned out to be very risky — and there was not enough equity to absorb losses.

It would be a disaster if this were to happen again. It is also highly unlikely that Mr. Tarullo and his colleagues will allow these shadows to develop without significant capital requirements.

Sebastian Mallaby, who has carefully studied hedge funds and related entities, asserted correctly last week in The Financial Times that it would be straightforward to extend higher capital requirements to cover shadow banking.

The fourth bankers’ argument, that higher equity requirements in the United States would create a competitive disadvantage vis à vis other countries, is like arguing in favor of the status quo in an industry that emits a great deal of pollution, a point made by Andrew Haldane of the Bank of England.

If China, India or any other country wants to produce electricity using a technology that severely damages local health, why would the United States want to do the same? And if the financial pollution floats from others to the United States through cross-border connections, we should take steps to limit those connections.

The Basel III issues may be boring, but they are important. The incorrect, misleading and generally false arguments of bank lobbyists should be rejected by regulators and legislators alike.

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