“TBTFA for TBTF”

Sydney M. Williams

Thought of the Day

“TBTFA for TBTF”

May 1, 2013

The acronymic title of today’s TOTD speaks to a rare, commonsensical, bipartisan proposed piece of legislation. Unfortunately, the fact that the bill is simple and would be easy to implement could doom it from ever being enacted. The President has already indicated he is against it, and for reasons that will become obvious, big banks don’t like it either. Everyone is familiar with TBTF (Too Big To Fail), which describes banks whose failure would threaten the financial stability of the United States. Despite the near collapse of our credit system in 2008 and the passage of Dodd-Frank two years later, surviving banks have grown even bigger…and riskier. TBTFA stands for Terminating Bailouts for Taxpayer Fairness Act, a bill that would force regulators to create new and simplified capital requirements. The important part of the bill is that the biggest banks – those that have the heft to create the most damage – would have the most stringent equity capital requirements, a recommendation that makes eminent sense.

A failure to pass and enact this legislation would be bad for taxpayers. But Congress, lawyers, bankers, regulators, rating agencies and a host of others don’t like simple. Their livelihoods depend upon complex. Dodd-Frank consisted of 2300 pages when it was signed into law in July 2010. Rules concerned with implementing the bill have added another 9000 pages. Complex means that millions of our tax dollars get spent on a bill no one fully understands and which appears to do very little to prevent a recurrence of those frightening weeks in the fall of 2008. But it does keep thousands of government workers employed.

The legislation producing TBTFA was proposed by two Senators – Sherrod Brown (D-OH) and David Vitter (R-LA). As Gretchen Morgenson wrote in Sunday’s New York Times, “It is a smart, simple and tough piece of work that would protect taxpayers from costly rescues in the future.” However, as federal taxpayers are soon to become a minority among voters, the interests of taxpayers become relatively less important to politicians.

An unintended consequence of Dodd-Frank is that it has allowed the largest banks to become bigger. An implicit government guarantee has lowered their costs of funding, providing the mega banks an unfair competitive advantage. The six largest banks, measured by assets, are nearly $2 trillion larger than they were five years ago. Off-balance sheet liabilities remain hidden. The Basel accords, which have established international standards for acceptable leverage, use a complex set of algorithms to determine risk-weighted ratios. The Bank of England’s Andy Haldane, the executive director for financial stability, has estimated that an average large bank would have to conduct more than 200 million calculations in order to determine their regulatory capital under Basel II. According to a Senate report, the average large bank’s risk-weighted Basel III ratio would allow banks to leverage their equity twenty-five times, leaving a cushion of 4% – not much in volatile markets.

TBTFA would require the largest banks – those over $500 billion in assets – to maintain 15% equity capital ratio, almost double the stated 8% risk-weighted assets required under Basel III. There are only six banks in the U.S. that meet that measurement, but at $7.9 trillion they represent about 55%. They are: JP Morgan Chase, Citigroup, Bank of America, Wells Fargo, Goldman Sachs and Morgan Stanley. Banks with assets in excess of $50 billion but less than $500 billion would be required to hold 8% in equity capital. Smaller banks would be required to hold equity capital of 10%. Those six banks hold assets that are roughly equal to 55% of all U.S. bank assets and approximate 50% of U.S. GDP. They’re big!

Under TBTFA, off-balance sheet assets and liabilities would be included when determining risk-weighted assets; thus the process would be far more transparent than it is today and would be under Dodd-Frank. Since leverage would be less, U.S. Banks would be precluded from meeting Basel III requirements. Basel’s rules are arcane and the calculations of risk-weighted assets depend on the same rating agencies that did such a poor job in 2007 and 2008. Additionally, Basel III allows bankers latitude to understate risks. Under TBTFA, the government safety net would be limited to traditional bank lending activities, not investment banking or trading.

The larger banks complain that the more stringent capital requirements would impede their ability to earn adequate returns. That may be true, but that is the point. The incentive is for the biggest banks to reduce their size below the $500 billion threshold, or to spin off businesses. As Andrew Ross Sorkin once wrote, “The trouble with banks too big to fail is that they are too big.” Are we, as a nation, better off with mega banks earning less, or with the risk that a bad bet could implode the financial system? Commerce, the life blood of economic health, is dependent on credit. Were it to be impaired, the consequences would be devastating.

While opponents to TBTFA, including the President, claim that Dodd-Frank addresses the question of risk, the markets disagree. Funding costs for big banks (those deemed too big to fail) is lower than equivalent costs for regional and community banks. The International Monetary Fund and the Bank for International Settlements estimate that the implicit TBTF subsidy to the six largest banks is between $50 and $100 billion per year. The subsidy is based on the market’s assumption that taxpayers will back-stop losses for the biggest banks in case of default. Is the market wrong? Perhaps, but keep in mind, markets are dispassionate; they have no biases, or political axe to grind, whereas people – bankers, regulators and politicians – do. As Dallas Fed President Richard Fisher said, in a recent speech in Maryland, “[The current system] is patently unfair. It makes for an uneven playing field, tilted to the advantage of Wall Street against Main Street, placing the financial system and the economy in constant jeopardy.” Why should politicians who purport to represent the average person support Wall Street over Main Street? The answer, I fear, can only be cronyism, which is perhaps today’s greatest threat to democracy.

Dodd-Frank may have been well-intentioned, though I have my reservations, but its length and complexity mean that regulation will require hours of legal wrangling. In his March speech, Mr. Fisher noted that Congress’s Financial Services Committee estimates that it will take 24,180,856 hours each year to comply with the Act’s new rules – or an annual cost of between one and two billion dollars.

No one can possibly want a repeat of the events that led to the crisis in the fall of 2008. We can Monday-morning quarterback as to what should have been done and what was done that should not have been done. But events such as the bankruptcy of AIG, the forced sale of Merrill Lynch or the breaking of the dollar by the Reserve Primary Money Market Fund could have caused runs on banks. The immediate instinct of people is to protect what they have, to withdraw cash from banks and money market funds. But that did not happen. At that moment, it was critical for the Administration to support the banking system, which meant supporting Wall Street. For the success of their intervention, we all owe a debt of gratitude to those in charge at the time. The system was stabilized fairly quickly, though risks persisted and the stock market did not bottom until early March. But high yield bonds had begun to recover by the end of November, and the TED spread had narrowed by three hundred basis points by the end of 2008. The heat of the crisis was over before Mr. Obama took office. The new Administration should have pivoted toward Main Street, but they did not.

Commerce relies on credit, and the credit system depends on cash being circulated from depositors to borrowers with banks acting as intermediaries. A bank run can have a domino effect, causing a meltdown of the financial system. It did not happen in 2008, but that does not mean it could not happen at a future date. Banks are larger than they were, with balance sheets murkier than ever. The game that is being played is far too serious not to impose rules as logical and as easily understood as those in the bill proposed by Senators Brown and Vitter.

Dodd-Frank is not the answer. TBTFA would be far simpler and more effective. It is in the interest of us all that Congress and the President support this practical and easily enforceable legislation.