With a simple albeit ambitious decision, Wall Street regulators have a way to all but guarantee that there will be no more financial sector bailouts: require genuine "skin in the game" from bank owners.
On Monday, Oct. 22, federal banking regulators will close the public comment period for their proposed reforms of so-called capital requirements. Capital requirements are the shorthand for the proportional amount of shareholder money that a bank must include as part of any loan or other activities. The purpose of capital rules is to link money borrowed from depositors and other creditors to the bank. Together, stockholder and depositor money is loaned to businesses, home buyers and other bank clients. If a client can't repay the whole loan, that loss should come out of the pocket of the stock investor, not the depositor or taxpayer.
Going into the financial crisis, large banks had effectively loaned out $33 for every $1 in stockholder money. When the housing bubble burst, speculation deals vaporized, and the measly $1 in shareholder investment was not nearly enough to keep large banks such as Bank of America solvent. American taxpayers were then forced to invest $700 billion into bank capital accounts through the bailout, with the Federal Reserve shoveling trillions more in cheap credit for the banks.
To avoid a repeat of this disaster, the required investment from shareholders must be substantially increased.
American bank regulators have proposed capital improvements as part of an international effort negotiated in Basel, Switzerland. This effort began in the 1980s, and we're now at "Basel III." The current proposal from the Federal Reserve, Federal Deposit Insurance Corp., and the Office of the Comptroller of the Currency spans 1,000 pages. The text contains more mathematical formulas than a calculus textbook. By comparison, the Volcker Rule, designed to terminate high-risk bank speculation and much maligned for its complexity, is a Reader's Digest at 300 pages.
The 1,000 pages of new requirements represent a lot of trees, both literally and figuratively, but the regulators fail to evince a view of the forest. Most problematic, the regulators essentially leave basic capital levels untouched, at about the same $33-$1 level that prevailed during the global financial meltdown. This fact upsets leading Washington policy-makers, both Republican and Democrat.
On Oct. 17, U.S. Sens. Sherrod Brown (D-Ohio) and David Vitter (R-La.) fired off a letter to the regulators declaring that capital requirements must be strengthened. Their letter stated that there is "bipartisan consensus among members of the Senate Banking Committee that it is appropriate to require banks to fund themselves with equity sufficient to withstand sufficient economic shocks."
Earlier this month, two dozen former regulators, both Republican and Democrat, led by former Federal Deposit Insurance Corporation (FDIC) Chair Sheila Bair and Federal Reserve Chairman Paul Volcker called for shareholder capital equal to 16 percent of the bank's activities. Sitting FDIC Vice Chair Thomas Hoenig agrees that the required capital should be substantially higher than currently proposed in the harmonization accord.
Other experts, such as MIT economist Simon Johnson and Stanford University professor Anat Admati, call for 20 percent at-risk investment. Admati emphasizes that high capital won't sit idly in a cookie jar like a rainy day fund. Other companies, such as Apple Inc., finance themselves entirely with at-risk equity capital. With sound capital requirements in place, the regulators behind the harmonization accord could dispense with the second major problem with their proposal, namely risk-weighting. This counterproductive practice allows banks to hold less capital for some types of financial activity. For example, if risk-weighting provisions are implemented, JPMorgan Chase would need less investor capital for a loan to a faltering big bank like Bank of America than for a loan to a profitable, growing company like Apple Inc. Absurd.
The risk-weighting rules are complex, a "tower of Basel," according to Bank of England director Andrew Haldane. In effect, the weights become "central planners' determination of risks, which creates its own adverse incentives for banks making asset choices," according to the FDIC's Hoenig.
Banks want simplicity? Here you go: In Public Citizen's comment letter, we call for a strict capital requirement of 20 percent, with no hall passes for risk weighting.