Our Simplicity Fetish in Banking

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The new banking bill from Senators Sherrod Brown and David Vitter has had some glowing reviews. And that doesn't surprise me at all, because the headline of the bill has in spades what Dodd-Frank notably lacked. In a word: simplicity.

In fact, the Senators highlight just that fact right at the beginning of the bill's one-pager (opens a PDF), noting that the bill would "institute new capital rules that don't rely on risk weights and are simple, easy to understand, and easy to comply with."

There's a lot to applaud in that, especially in concept. And I imagine that the fan club for the bill will continue to grow, because there has been a growing drumbeat for simplicity ever since the financial crisis helped bring the U.S. economy to its knees. There's no doubt that we should push for more clarity and simplicity in some areas -- consumers should truly comprehend their credit card statements, and borrowers should mean it when they say they understand their mortgages.

But should the average Joe on the street really be able to digest the intricacies of what's on a bank's balance sheet? Can we really expect that a major global bank's annual report should read like that of a small community bank?

Bank of America  (NYSE: BAC  ) , JPMorgan Chase  (NYSE: JPM  ) , Citigroup  (NYSE: C  ) , Wells Fargo  (NYSE: WFC  ) , Morgan Stanley  (NYSE: MS  ) , and Goldman Sachs  (NYSE: GS  ) are the primary targets of the bill, as it would require a draconian capital buffer on any bank with assets above $500 billion. It would also do away with the use of risk-weighted assets, which allows banks to carry less capital for assets deemed less risky. It's essentially a big, blunt club that batters the biggest banks with a 15% capital requirement.

Some will undoubtedly pump their fists, look back at what was, and point out that a 15% capital buffer might have headed off the need to bail out Citigroup -- and perhaps that's true. Maybe it would've helped with B of A, too. Though if B of A had been working under those capital constraints, would it have acquired Countrywide? If not, we wouldn't have had that gigantic mortgage implosion on our hands.

You might be tempted to think that the Lehman story would have ended differently, but it never converted to bank holding status, and so these rules wouldn't have applied. Goldman and Morgan Stanley weren't banks until well into the middle innings of the crisis; while it would apply to them now, it wouldn't have then.

And what of JPMorgan and Wells Fargo? There's a very valid argument that Warren Buffett's favorite bank -- Wells, that is -- didn't need a bailout at all. It's not entirely crazy to say the same of JPMorgan. Slap huge capital requirements on these banks, and you may inhibit their ability to step in and save other huge, flailing institutions. Washington Mutual would have been too small to qualify for the largest capital buffer, and Bear Stearns would have ducked the requirements, because it wasn't a bank holding company. JPMorgan probably headed off significant (further) market dislocations by acquiring both.

This also ignores the reality that, while the biggest banks did pose a particularly ominous threat as they teetered on the edge of failure, there was a significant number of smaller banks that failed. One hundred and forty FDIC-insured banks failed in 2009. Another 157 were shut down in 2010. And 143 joined the ranks during 2011 and 2012. The country's biggest banks did not have a monopoly on mismanaging their balance sheets in the years before 2008.

In concept, I like the idea of keeping things simple. But I think there are also hidden risks in the simplicity here. For one, I can't help but wonder if this will actually encourage risk taking from some banks. If you essentially say that Wells Fargo has to maintain the same amount of capital as Morgan Stanley, despite vast differences in their balance sheet composition, you may be implicitly telling Wells to amp up the risk it's taking.

We also need to recognize that, sometimes, more complexity is beneficial. A decade ago, I was working on mostly desktop computers, and could easily open one up to swap out and upgrade components. Today, the miniaturization and complexity of a laptop's innards mean that I can no longer do that. But laptops don't make me panic -- I'd say that I'm better off for having the laptop, complexity and all. Mortgage-backed and other structured securities might as well be four-letter words today, but there's value in having relatively complex risk-distributing products like them.

Finally, for all the ballyhooed simplicity, I see this bill as trying to sidestep the simplest solution of all: allowing failure. In attempting to load the banks up with so much capital that they "can't" fail, we run the risk of creating a dangerous implicit assumption. 

Banking is a business best done with a conservative hat on. But at the same time, every time a loan is made, a banker is taking a risk. Fifteen percent capital buffer or not, mistakes will be made. When that happens, the bank that made the mistakes should suffer.

In the end, it's not about an 8%, 15%, or 25% capital buffer. It's about having a banking system where a bank that gets it wrong can fail without bringing down the entire system. If some banks truly are so big that we can't possibly have them fail, then we either need to tweak the system so that they can safely fail, or stop pussyfooting around: just break them up.

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  • Report this Comment On May 03, 2013, at 10:04 AM, CUInHawaii wrote:

    I think what we really need to do is to create a system where the big banks can fail without bringing down the system.

    - Raise the FDIC insured limit substantially ($1M maybe; along with the fees banks pay, accordingly)

    - Tie the FDIC insured limit to inflation such that we don't need to tweak the limit again

    - Somehow encourage the banks to not be tied to each other. A failing bank should help the others as customers move, rather than bringing the bank down as bank A was invested in bank B's success.

  • Report this Comment On May 03, 2013, at 3:58 PM, Mega wrote:

    The effect would be losing a ton of financial business to London and Hong Kong among other places. It would be an ongoing drag on US GDP. And it would (eventually) increase interest rates as large banks struggle to achieve ROE with reduced leverage.

    Breaking up the big banks would be a better approach than punishing them with uncompetitive capital requirements.

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