Do Big Banks Need Another $1.1 Trillion in Equity Reserves?

Are the biggest banks victims of their own success? As the largest institutions such as Bank of America (NYSE: BAC  ) and JPMorgan Chase (NYSE: JPM  ) build themselves back up from the wreckage of the financial crisis, some are asking whether the regulations put in place since then are enough to prevent another meltdown.

Additionally, as banks show that they can fulfill these new obligations and still continue to recover, fresh, more onerous rules are pending to insure that their problems won't again adversely affect the greater economy. One of these new rules, put forth by U.S. Senators Sherrod Brown, D-Ohio, and David Vitter, R-Louisiana, would pump up capital requirements to the point where some big banks claim that lending would suffer.

The biggest would need the most
The Brown-Vitter bill would require all banks to sock away enough capital to equal 10% of their assets, and those with assets of more than $400 billion would be obliged to hold even more -- up to 15% in total. This list includes , in addition to JPMorgan and B of A, Citigroup (NYSE: C  ) , Wells Fargo (NYSE: WFC  ) , Goldman Sachs (NYSE: GS  ) , Morgan Stanley, and General Electric's (NYSE: GE  ) GE Capital. What would be the effect of such a law? Needless to say, it depends upon who you ask.

Banks, naturally, are against any more capital rules, claiming that more restrictions would impede their ability to make loans and crush the incipient economic recovery. According to Goldman Sachs, U.S. banks, in totality, would be required to hold an extra $1.1 trillion in equity to satisfy this new rule. The effect of this huge cushion would be a reduction in return on equity from 11% to 5%, as well as a 25% drop in funds available for lending -- taking $3.8 trillion out of the lending pipeline. According to Goldman, bulking up to this extent would take the systemically important institutions approximately 12 years to achieve -- but the law would allow only five.

Would these regulations truly produce such angst? Perhaps the banking industry is overstating a bit. A recent Bloomberg editorial on this subject took a reasoned look at the law, noting that the banks are only being asked to fund their everyday business with their own cash, rather than through the risky third-party repurchase market -- the cause of the infamous "run on repo" that actually triggered the financial meltdown in the first place. Is that really so much to ask?

Banks think so, but no one should be surprised that the industry is resisting yet another round of rules that might squeeze profits. But for banks, investors, and taxpayers, smaller, safer profit levels must surely be preferable to huge gains followed by a bigger crash. If Brown-Vitter gets an airing and a nod, the financial world just might become a safer place.

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  • Report this Comment On April 22, 2013, at 11:56 AM, PsimsHPS wrote:

    Brown and Vitter don’t like to acknowledge that the issue of too-big-to-fail is already being addressed in Dodd-Frank, yet the law has had a significant impact on increasing bank safety and ending government bailouts. Jeremy Powell of the Federal Reserve discussed this very topic in a recent speech.

    Powell Argues Dodd-Frank Efforts On TBTF Are Promising: "The market needs to believe—and it needs to be the case—that every private financial institution can fail and be resolved under our laws without imposing undue costs on society. The current reform agenda is designed to accomplish just that, through two channels. First, it is intended to substantially reduce the likelihood of failure through a broad range of stronger regulation… Second, it is intended to minimize the externalities from failure by making it possible to resolve a large financial institution without taxpayer exposure and without uncontainable disruption. If these reforms achieve their purpose, in my view they would be preferable to a government-imposed break-up, which would likely involve arbitrary judgments, efficiency losses, and a difficult transition." (Jerome Powell, Remarks At The Institute Of International Bankers, Washington D.C., 3/4/13)

    And according to the data, we are already seeing changes in bank safety and market perception of future bailouts.

    Zandi Says Banking System Is "Arguably As Strong As It Has Ever Been." "'The banking system is arguably as strong as it has ever been,' Mark Zandi, Moody’s Analytics chief economist, said. 'Capital is at record levels, and there is ample liquidity. Credit quality is good and improving rapidly.'" (Danielle Douglas, "Is The Banking System Healthy?," The Washington Post, 2/18/13)

    The Swaps Markets Are Recognizing That Large Banks Are Less Likely To Be Bailed Out. "UBS strategists led by Robert Smalley also expect Moody’s to cut its ratings by one level as the probability for state support diminishes, according to an April 2 report. That would leave creditors of the holding company more vulnerable to losses as regulators develop an alternative strategy. 'The swaps market is beginning to acknowledge that,' Smalley, based in New York, said in a telephone interview." (Charles Mead, "Too Big to Fail Discounted as Moody’s Evaluates: Credit Markets," Bloomberg, 4/10/13)

    Increasing capital ever higher comes at a tradeoff of economic growth.

    The Trade-Off Between Capital Levels And Growth Is Widely Recognized. "There is little argument that higher capital standards may slow growth, but the scale of the effect is in dispute. The New York Federal Reserve reckons that for each percentage point of extra capital that banks must hold, economic growth slows by about 0.09% a year. The Basel Committee and the Bank for International Settlements reckon the damage is only about a third of that and that it disappears over time. The OECD has come up with a range so wide that it can be reconciled with both. And the Institute of International Finance, a club of banks, reckons the impact could be up to ten times bigger." ("Bank Capital: How Much Is Enough?," The Economist, 5/12/11)

    Elliot Argues The "Dangerous Misconception" That There Is No Trade-Off Between Capital And Lending Is False. "A dangerous misconception appears to be taking root in the public debate about bank safety. A belief is growing that banks could be made much safer, at essentially no economic cost, by requiring shareholders to supply far more of the funding for banks with correspondingly less coming from debt holders and depositors. In fact, there would be significant economic costs, so there needs to be a debate centered on an examination of the trade-offs. Personally, I agree with the majority of analysts and policymakers that the costs would outweigh the benefits, but my key point here is that we need a debate on the trade-offs, wherever we come out on them." (Doug Elliot, "Higher Bank Capital Requirements Would Come at a Price," Brookings Institute, 2/20/13)

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