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New ideas to end the notion that some banks are too big to fail are welcome, even if they are flawed. A coming U.S. bill will try again to prevent future bailouts by forcing big banks to hold more capital against total, not risk-weighted, assets.
Even after the 2010 Dodd-Frank Act, the bailout worry persists. Giving regulators more power to wind down or resolve big failing institutions is useful, but for international firms there are still cross-border jurisdictional issues. There's a camp that favours breaking up behemoths, represented by Dallas Federal Reserve president Richard Fisher, among others, though the practicalities are challenging. A more general approach, built into international Basel III guidelines and embraced by the Washington Fed and other watchdogs, is to force large banks to hold a bigger buffer against trouble – an approach that eventually makes size unprofitable.
The latest initiative in Congress is in this vein, but with a twist. Regulators typically measure capital against risk-weighted assets (RWAs), with holdings perceived as riskier requiring a fatter loss-absorbing cushion. A bipartisan bill expected this month will suggest measuring capital simply against total assets.
This would counter the leeway banks and supervisors have in calculating RWAs – a bone of contention between U.S. and European banks, for example – and the danger that regulators assign too low a risk rating to particular investments. Low risk ratings on certain assets can encourage banks to pile into them and that can be systemically damaging if they go bad, as happened with mortgages last decade. A basic equity-to-total-assets ratio is another way of thinking about how banks should fund their balance sheets, and has the merit of simplicity.
But abandoning consideration of the riskiness of assets has flaws, too. Banks could load up on, say, high-yielding junk bonds and become more vulnerable to failure, not less. So measuring capital against total assets might only make sense in combination with other measures.
Moreover, banks would have to raise more capital, further denting their profitability. The 18 U.S. institutions stress-tested by the Fed last month boasted $792-billion (U.S.) of Tier 1 common equity at the end of 2012, an average of 11.3 per cent of their RWAs. For 2011, researchers at the International Monetary Fund pegged RWAs at 57 per cent of total assets for U.S. banks.
Using those figures, to reach a 10 per cent ratio of equity-to-total assets – a figure doing the rounds – the typical bank might have to increase its capital by more than 50 per cent. The six largest banks, facing a surcharge, could need to more than double their existing $609-billion of capital.
There aren't simple answers. Yet after the painful 2008 crisis, strengthening banks against turbulent times remains important – for shareholders as well as lawmakers. The latest U.S. legislative effort may well come to nothing. But at least it will help keep that goal front of mind.