Banking Regulation: Closed for Business

These are heady times for the bipartisan group of reformers seeking a safer and more manageable U.S. financial system. The leaders of this movement, Senators Sherrod Brown and David Vitter, introduced legislation yesterday to force the biggest banks to foot the bill for their own mistakes by imposing higher capital requirements. The bill would increase equity (either retained earnings or stock) in the financial system by $1.1 trillion and incentivize mega-banks to break themselves up, according to a Goldman Sachs report. Brown and Vitter previewed the legislation earlier this week at the National Press Club, insisting that the new regulations on risky mega-banks would diminish threats to the U.S. economy and prevent taxpayers from having to bail out banks in the future. Vitter also said the legislation would “level the playing field and take away a government policy subsidy, if you will, that exists in the market now favoring size.” With momentum, broadening support, and tangible legislation to push, bank reformers feel better positioned for success than they have since the passage of Dodd-Frank.

Or rather, they did until the Treasury Department poured a giant bucket of cold water on their effort. In a speech to the Levy Economics Institute of Bard College's annual Minsky Conference last Thursday, Undersecretary for Domestic Finance Mary Miller claimed that Dodd-Frank had already solved the “Too Big to Fail” problem. Miller indicated that mega-banks do not enjoy an unfair advantage in their borrowing costs and that recent boosts to capital standards were already working to strengthen the financial system. Having a big public speech at an important venue by a top official the week before the release of Brown-Vitter sends a clear message about the Treasury’s position. “She is not going off the cuff in a policy speech like that,” said former Special Inspector General for the Troubled Asset Relief Program (TARP) and persistent bank critic Neil Barofsky. “This seems like a carefully measured response to Brown-Vitter that the regulatory-reform shop, from the Treasury perspective, is closed.”

The resistance should not surprise anyone. Under Timothy Geithner, Treasury was openly hostile to far-reaching congressional proposals to constrain mega-banks. Despite the change in leadership at the department, many holdovers from the Geithner era, including Miller, still hold high-level positions. In his confirmation hearings, Treasury Secretary Jack Lew stated flatly that Dodd-Frank had dealt with the Too Big to Fail problem. Most important, Lew works for President Obama: Reaching an agreement to break up mega-banks by forcing them to carry more capital would represent a tacit admission that Dodd-Frank, widely touted as a centerpiece of the president's first term, failed in its core mission of stabilizing the financial system.

What’s striking about Miller’s speech is how closely it mirrors the arguments set forth in several recent papers put out by the big banks, their lobbyists, and their allies. This includes the previously mentioned report on Brown-Vitter by Goldman Sachs; a policy brief by the Financial Services Forum and co-signed by the leading lobbyist groups for the banking industry; and a report with the cheery title “Banking on Our Future” by Hamilton Place Strategies (HPS), a public-relations firm staffed by top communications officials from the last three Republican presidential campaigns (HPS has admitted that its clients include large financial institutions). All of these reports were released in the past few months in an effort to derail Brown-Vitter. Given that Miller is a 26-year veteran of the investment-management firm T. Rowe Price, it is no surprise that she espouses Wall Street’s worldview.

For example, Miller discounts an influential working paper from the International Monetary Fund (IMF) showing an $83 billion annual subsidy for mega-banks from their Too Big to Fail status by saying its evidence “predates the financial crisis and Dodd-Frank’s reforms.” This is precisely the argument the Financial Services Forum made, ignoring the fact that there are plenty of post-crisis studies that show the subsidies persist. Miller highlights the resolution authority granted to the Federal Deposit Insurance Corporation (FDIC) under Dodd-Frank, which allows the FDIC to wind down any systemically important financial institution verging on collapse rather than resorting to a bailout. She says that, to the extent that a cost-of-borrowing advantage exists for mega-banks, resolution authority “should help wring it the rest of the way out of the market.” In practically the same language, HPS writes that resolution authority “helps eliminate any potential funding advantage big banks are thought to have.” And in providing statistical support for increased capital, Miller notes, “The 18 largest bank-holding companies … doubled the amount of their Tier 1 common equity capital over the last four years.” Goldman Sachs uses precisely this statistic, writing that “common equity has doubled for U.S. banks” since the financial crisis.

Critics have assailed the bank-industry papers for their unrealistic views about the risks in the current system and over-optimistic evaluations of the impact of the most recent regulatory changes. The truth is that Dodd-Frank has emerged from the gate slowly, bank lobbyists have successfully gutted many of its provisions, and much of it remains in flux. Miller approvingly highlights the Volcker rule as a key financial reform, but the final rule has been delayed nearly a year and has yet to be adopted. The proposed rule to tax systemically important institutions, for example, would cost as little as $28 million, about .2 percent of annual earnings. Other provisions like resolution authority could prove unworkable in an interconnected, global financial system and amid the pressure of catastrophic collapse. Stanford economics professor Anat Admati, author of the book The Banker’s New Clothes, does not believe Dodd-Frank will hold up in a crisis, comparing it to “preparing for a disaster like an earthquake by putting an ambulance at the corner.”

Since Brown-Vitter relies so heavily on imposing new capital requirements, Miller’s alignment with the industry on capital is the most telling section of her speech. Miller says that recently imposed capital rules—negotiated under an international process in Basel, Switzerland—are sufficient for banks to cover their own losses. But while the Basel rules as much as tripled capital requirements, as the Financial Times’s Martin Wolf quipped, when the standards were released in 2010, “tripling almost nothing does not give one very much.” Critics also argue that current capital rules afford banks far too many opportunities to use creative accounting to game the system. The rules allow banks to calculate their capital needs using “risk-weighted” assets, counting each type of asset differently based on its assumed level of risk. Banks use risk-weighting to sharply reduce the amount of capital they have to hold—by as much as 50 percent, according to some calculations. In the event of a systemic collapse where all assets fail, regardless of the accounting games, banks would not have the funds necessary to stay solvent. Indeed, during the 2008 financial crisis, investment banks like Lehman Brothers were allowed by the Securities and Exchange Commission to risk-weight assets, and nearly all of them failed. Meanwhile, Sheila Bair at the FDIC rejected risk-weighting, and the commercial banks her agency insured fared better. Brown-Vitter would ban risk-weighting in their capital standards, but Miller simply counsels to stay the course.

Treasury’s rejection of Brown-Vitter has serious implications. On Monday, Senate Banking Committee chairman Tim Johnson reacted to Brown-Vitter by saying that regulators should finish implementing Dodd-Frank before Congress moves to enact additional reforms. Johnson didn’t cite Miller’s speech, but he didn’t have to: Democratic leaders in Congress will naturally resist turning against the wishes of their president and his economic team. And many rank-and-file lawmakers will cede to the perceived expertise of the Treasury Department. This gives Treasury outsized control of the financial-reform debate, which they’ve used to weaken and soften reforms at virtually every step of the Dodd-Frank process and beyond. In fact, Treasury officials credit themselves with stopping Sherrod Brown’s 2010 proposal to cap bank size. An anonymous senior official said at the time, “If we’d been for it, it probably would have happened. But we weren’t, so it didn’t.”

This all means that Brown-Vitter is likely to sit on a shelf unless and until Wall Street generates another crisis. With Sherrod Brown in line to potentially take over the Senate Banking Committee in 2014, reformers may benefit from the wait. But it will be a wait.

Financial-reform advocates see Brown-Vitter as a major opportunity for President Obama to “get on the right side of history” and address the continued riskiness and complexity of modern finance. But Treasury’s primary concern appears to be limiting any constraints on the record profits of those mega-banks, rather than protecting the public from threats to the rest of the economy. As Barofsky concluded, “Treasury has defended the status of the Too Big to Fail banks every step of the way, why would they stop now?”

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