While nearly everyone knows the U.S. government bailed out the largest U.S. banks through the Troubled Assets Relief Program, the senators conveniently left out the fact that most of the funds extended to banks though the Troubled Assets Relief Program, or TARP, have been repaid, with plenty of interest, that TARP has been profitable. The senators said in their press releases that "five years ago, risky practices at Wall Street banks puts our economy on the brink of collapse -- and jeopardized the savings and pensions of millions of Americans. Today, the nation's four largest banks are nearly $2 trillion larger than they were then -- aided by an implicit government guarantee awarded by virtue of their 'too big to fail' status."
"Our bill will ensure a level playing field for all financial institutions by ending the subsidy for Wall Street megabanks and requiring banks to have adequate capital to back up their liabilities," the senators said.
OversimplificationThe TBTF bill's capital requirements would be much more simple than the Basel III capital requirements for the largest banks, which will be fully phased in by January 2019 under the Federal Reserve's proposed rules. The Fed's rules would require large banks to have Tier 1 common equity ratios of 7.0%, plus additional requirements for "globally systemically important financial institutions," or GSIFIs.
For Bank of America ( BAC) and Wells Fargo ( WFC), the surcharge is 1%, for fully phased in Basel III Tier 1 common equity ratio requirements of 8.0% for each company. Senators Brown and Vitter said that under their proposal, "regulators would walk away from Basel III, and institute new capital rules that don't rely on risk weights and are simple, easy to understand, and easy to comply with." They also said in their press release that the biggest banks "will be faced with a clear choice: either become smaller or raise enough equity to ensure they can weather the next crisis without a bailout." When the senators say their rules "don't rely on risk weights," they mean that banks will be required to set aside the same amount of capital for cash as they would for junk bonds. Mayra Rodriguez Valladares -- managing principal of MRV Associates, a financial regulatory consultancy -- says that the simplified capital rules excluding risk-weighting would provide "perverse incentives for traders to go into riskier assets, because they wouldn't be punished from a capital requirement perspective." Rodriguez Valladares says this phenomenon was already observed under the Basel I capital rules, which is why Basel II included risk-based capital requirements. Kevin Petrasic -- a partner in the Global Banking and Payments Systems practice of Paul Hastings in Washington -- says "the notion of not having any sort of risk-weighting raises some concerns," adding that the straight 15% capital-to-assets requirement for the largest banks would have "economic consequences that need to be weighed carefully."
Headaches for Banks and RegulatorsSenators Brown and Vitter said their new rules would "focus on common equity and other truly loss-absorbing forms of capital." While it certainly was an impressive thing for the senators to say, this has already happened under the Dodd-Frank Wall Street Reform and Consumer Protection Act, which was signed into law by President Obama in July 2010.
Under Dodd-Frank, most forms of trust-preferred equity are excluded from banks' regulatory Tier 1 capital. Cumulative preferred shares are also excluded, which is why the nation's large banks over the past year have been redeeming trust preferred shares and issuing noncumulative perpetual preferred shares. The latter are allowed to make up a relatively small portion of Tier 1 capital. The noncumulative preferred shares are considered a "higher quality" of capital than cumulative preferred shares, since banks are free to suspend dividend payments without having to make them up later. Basel III takes a similar approach on the quality of regulatory capital. According to Rodriguez Valladares, "European and Japanese regulators have long advocated for different assets to be used as capital. Americans have said that retained earnings and common stock were the best forms of capital, because they have real ability to absorb losses. U.S. Regulators finally won this battle with Basel III." Dodd-Frank has also led to a much stronger supervisory role for the Federal Reserve, including annual stress tests and reviews of banks' capital plans. This year's stress tests gauged the banks' ability to weather a "severely adverse scenario," including an increase in the U.S. unemployment rate to over 12% in the second half of 2013, with a 50% drop in equity prices and a 20% decline in real estate prices. Following the stress tests, the Fed applied the same harsh scenario to large banks' plans to deploy excess capital through dividend increases and share buybacks. "Banks have already spent billions of dollars to upgrade their management information systems to comply with Dodd-Frank and Basel III," according to Rodriguez Valladares. The Federal Reserve is working to finalize various regulations based on requirements of Dodd-Frank, including enhanced capital requirements and the Volcker Rule, which bans proprietary trading by banks that gather deposits insured by the Federal Deposit Insurance Corp. "It is not the job of politicians to set capital standards. It is the job of bank regulators by law, reinforced by Dodd-Frank, to come up with the standards," Rodriguez Valladares says.
"If the Federal Reserve wanted to, the big U.S. banks could already be holding 16% capital, half risk-weighted and half not. It is already within the power of the Fed," she says, asking "why are we having this populist tirade, when nothing new is being proposed?"