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Big Bank Phobia: Not Too Big to Fail

Brown-Vitter emphases a preference for common equity rather than preferred or trust preferred equity, most of which has already been excluded from regulatory capital under Dodd-Frank. More importantly, the simplified approach under Brown-Vitter means the denominator of the capital ratio will no longer be risk-weighted.

Under Basel III, cash has a zero risk-weighting, so it is not added to risk-weighted assets and it doesn't increase a bank's capital requirement. Direct obligations of the U.S. government have a 20% risk-weighting. Mortgage-backed securities with AAA or AA ratings have a 20% rating. A-rated MBS have a 50% risk-weighting, while BBB paper has a 100% risk-weighting, and BB paper has a 200% risk-weighting under Basel III, because of the higher likelihood of default.

Brown-Vitter would treat cash and the lowest quality junk bonds, or even nonperforming loans, as having the same amount of risk. This is counterintuitive, since it could only lead to banks taking more risk, since there would be no capital penalty for doing so.

So rather than taking a direct approach to breaking up the largest U.S. banks, Brown-Vitter seeks an indirect approach of raising the capital requirement so high that the banks and their investors would eventually throw in the towel, after realizing their returns on equity would be too small to justify their size. If only those simplified capital requirements weren't so dangerous.

Arguments Against Breaking Them Up

"We have had a system that has tried to keep banks small since Andrew Jackson," Mosby says, adding that the restrictions against preferred and trust preferred equity under Dodd-Frank, and proposed under Brown-Vitter, are counterproductive. "The capital protecting depositors is all value and the productive part of other sources of capital is that they are much lower in cost. It would be better to allow banks like other corporations to use preferred stocks and to enhance their profitability, because that is your first line of defense."

"Quality is what matters, not just how big you are," he says.

Mosby in his May 13 report listed seven "alternative proposals" to breaking up the big banks. These include allowing banks to "utilize the full array of capital sources," as described above. The analyst's proposals also include a risk-based approach to capital requirements and two other elements of Dodd-Frank: Limiting "broker/dealer activities to just market making," and finalizing "an orderly liquidation process" for failing institutions.
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