Banks are Still Too Big to Fail

An article by New York Institute of Finance instructor Robert Jozkowski.

While Central Bankers and the Basel Committee express satisfaction at the newly promulgated Basel III capital requirements the global banking system remains at risk in the event of another crisis. During the financial crisis just five years ago the U.S. financial system teetered on the brink as major Wall Street firms faced collapse or bailout. During the intervening years the six largest U.S. financial firms have only gained a greater portion of the banking market. Continuing a 25 year trend, our six largest bank holding companies currently have assets valued at just over 63% of GDP. Importantly, what remains an overlooked concern is the amount of banks’ contingent liabilities particularly those assets sold to Fannie Mae and Freddie Mac that have put-back potential. Maybe not a concern today, but it would be at the next market shock.

In a May 3, 2013 analysis, David Romer of U.C. Berkley observes that “… financial shocks as closer to commonplace than to exceptional is based on history.” Thinking that financial crises are black swans is self-interested and inaccurate. He then asked: “The question, then, is what to do.”

Perhaps not a chorus but rather a choir of voices is now advocating better capital adequacy reform than we see from Basel III. It intends to be a significant improvement over earlier rules by requiring increased capital. But highly complex models are employed that rely on a set of subjective, simplifying assumptions to align a firm's capital and risk profiles. Such models promise precision well beyond what can be achieved considering the complexity of U.S. banking. (I remember when Basel I was first mandated in 1988; after learning the new capital rules the first response from bankers was to formulate strategies to circumvent them.)

The new legislation proposed by Senator Sherrod Brown (Dem-OH) and Representative David Vitter (R-LA) appears to be the vehicle bringing new attention and focus to the shortcomings of capital reform and a safer financial system. It incorporates the ideas of Richard Fisher of the Dallas Federal Reserve on how to remove government guarantees; the critique of Basel III from Thomas Hoenig of the FDIC; and the lessons of Sheila Bair, a former chairman of the FDIC, on the failures of supposedly smart regulation.

A snapshot of Brown-Vitter comes directly from Senator Brown’s April 24, 2013 press release:

Set reasonable capital standards that would vary depending on the size and complexity of the institution.Economic and financial experts agree that adequate capital is critical to financial stability, reducing the likelihood that an institution will fail and lowering the costs to the rest of the financial system and the economy if it does.

Mid-sized and regional banks would be required to hold eight percent in capital to cover their assets
Megabanks – institutions with more than $500 billion in assets – would be required to meet a new 15 percent capital requirement
Community banks would remain unchanged by the legislation, as the market already requires them to maintain capital ratios approaching 10 percent of their assets

But capital adequacy alone is not enough. The death blow to banks like Lehman is not insufficient capital but illiquidity. In September 2008 Lehman and AIG weren’t able to trade out of their problem positions. A champion of the importance of tying capital and liquidity is Daniel Tarullo, a current Federal Reserve Governor. He advocates a sensible approach of simultaneously evaluating liquidity and capital standards together and requiring higher levels of capital for large firms unless their liquidity position is “substantially stronger than minimum requirements.”

Brown-Vitter does not seem likely to be enacted or even brought to a vote in Congress. The banking industry is mobilized against it. Nonetheless B-V’s content makes sense and may help carry the ball down field toward better more effective financial regulation.

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