Unintended Consequences

Last week, Bloomberg News reported on leaked draft bill language seemingly sponsored by Senators Sherrod Brown (D-Ohio) and David Vitter (R-Louisiana) which would hold all banks to a higher capital standard (at least 10%  tangible common equity for all banks) than the level required by Basel III.  It would also create an additional penalty capital surcharge of up to 5% on institutions larger than $400 billion in assets.

The capital standards "shall reflect the historical equity ratios chosen by large depository institutions before the advent of the Federal Reserve, federal deposit insurance, and the income tax encouraged depositories to favor more more highly leveraged deposit and debt funding."  So basically, the 19th Century railroad tycoon-era bank capital ratios in existence when bankers wore vests, pocket watches, and either sported pince nez eyeglasses or monocles.  It's back to the future, folks.

The Brown-Vitter draft also opts out of Basel III altogether, prohibits affiliate transactions in large banks, prohibits government support to non-bank affiliates, repeals Section 806 -Financial Market Utilities - of the Dodd-Frank Act (considered a back-door bailout), and ends the systemic risk exception established by the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA).  During the recent financial crisis, the FDICIA systemic risk exception was invoked for Wachovia, Citigroup, and for the establishment of the FDIC's Temporary Liquidity Guarantee Program.

The draft bill text can be found on Quartz.

First a couple of disclaimers, I am not enamored with Basel III in its current form.  It is an overly complicated, over-engineered structure that just begs to be gamed by the banks subject to its provisions.  It's complexity will create a growth industry in even more finely-parsed regulatory interpretations and more steady work for consulting firms.  Its own complexity dooms it to irrelevance as times and circumstances change.  Someone should have listened to Einstein when he said "Everything should be made as simple as possible, but not simpler."

On the mega-banks, I'm no advocate.  I believe a handful of the largest of them have become too large to properly manage, regulate, and supervise.  This belief also applies to the Federal government generally.  I remember a TV pundit years ago say  "Government is like alcohol.  It is medicinal and salubrious in moderate quantities, but in immoderate quantities, it creates dependency."  That thought could be extrapolated to the Too-Big-To-Fail banks.  We have become dependent on their continued existence because we fear the consequences of withdrawal.  I prefer the clean surgery of traditional anti-trust breakups - Standard Oil in the 1911, A.P. Giannini's  Transamerica in 1952, AT&T in 1984.

Focusing only on the (up to) 5% penalty capital surcharge part of the draft bill language, affecting a half dozen of the largest banks, the mechanism chosen by the drafters has the potential to raise systemic risk in the banking system, impose serious explicit and opportunity costs on both borrowers and savers, and may costs jobs as large banks reconsider the status of their present legal form and jurisdictions.  Higher capital requirements also mean less lending and economic development.

First, on increasing risks to the banking system and costs to borrowers and savers.  I hope you will agree that extra/excess capital has a cost.  Like any merchant, when the cost of one of your business inputs rises, you could pass those costs on to the consumer (raise loan rates or lower deposit rates), reduce overhead costs, or accept reduced profitability.  The ability to pass on costs by raising prices is constrained by the elasticity of demand for your products and market structure of your industry. A monopolist would have little problem passing  increased capital costs along in the form of higher prices  The banking industry in the United Sates, however, is more like an oligopoly.

According to the FDIC, in 2011, there were 7,357 banks and thrifts.  Of those, 107 (1.5%) were banks and thrifts over $10 billion in assets.  Those 107 banks and thrifts represented 80% of industry assets.  The top four banking organizations (JPMorgan Chase, Bank of America, Citigroup, and Wells Fargo) alone accounted for 44% of industry assets. 

If we believe economic theory on oligopolies, the largest banks, having roughly half of the industry's market share, are market price leaders in terms of sending product price signals to the rest of the industry.  A prime or base rate, for example, might have a spread of 3.5 or 4 points over the fed funds rate, rather than the present 3 point spread.  However, those banks may be constrained in their pricing behavior, to a large degree, by the next tier of banks, the smaller nationwide and regional banks.  Those banks, who themselves constitute about a third of the market, would likely wholly or partially offset the ability of the largest banks to fully pass on capital costs to borrowers and savers by offering more competitive pricing themselves.

But it is also possible that this next tier of banks might also collectively (but not collusively) prefer to harvest a healthy portion of the potential gains from a price increase, while still also positioning themselves as a slightly more competitive offer in the marketplace for loans or deposits.  To the extent the next tier collectively decides to ride on the coattails of some portion of a first tier banks' price increases, those costs are borne by borrowers and savers.  But nevertheless, the ability of the largest banks to pass on the full costs of the higher penalty capital requirements is limited, to some unknown degree, by the structure of the U.S. banking market. 

So, while not having fully recouped the full increase in the cost of capital, what is a bank subject to the higher costs of a penalty capital surcharge to do?  The temptation is to reach for yield through "down and out" banking - down the credit quality scale and out along the yield curve (or also out of local markets, out of historic product lines, and out of the country).  So a panoply of systemic credit, interest rate, and liquidity risks could, counter-intuitively, actually increase under Brown-Vitter's penalty capital requirements.

And, finally, since other countries are unlikely to reciprocate with their own version of 19th Century capital standards, bank boards of directors involved have an obligation, perhaps a duty, to consider the best interest of bank shareholders relative to determining the bank's ongoing official domicile, legal forms, and the distribution of its jurisdictional presences.  Regulatory arbitrage cannot be ruled out.  

It's possible that the (up to) 5% penalty capital surcharge is meant to create an incentive for the voluntary breakup of the six banking organizations affected.  Why dither with an incentive if you can issue a breakup mandate?  A breakup could actually be win-win for everyone.  According to the Economist magazine, John D. Rockefeller profited handsomely from the breakup of Standard Oil as its pieces were worth far more apart than together.  The shareholders of these six banking organizations could reap similar benefits.  A piece of a Vampire Squid, anyone?