Economics, Financial Services, Pethokoukis, Regulation

GOP finally gets moving on shrinking Wall Street’s Too Big To Fail megabanks

Credit: Benjamin Dumas (CC BY-NC-SA 2.0)

Credit: Benjamin Dumas (CC BY-NC-SA 2.0)

Here’s what the movement to break up the big banks, or BUBB, is: A pro-market, anti-crony capitalist effort to minimize the moral hazard and massive taxpayer liability potential created by Washington’s Too Big To Fail subsidy of America’s largest banks.

Dodd-Frank isn’t the solution. What is? Maybe restructuring the TBTF banks. Or capping their size. Another possible method is forcing them to hold a lot more capital. That’s the option being pushed in a new bill from Rep. John Campbell, a California Republican. Here are its key elements, according to Bloomberg:

1. Campbell’s bill would require banks with at least $50 billion in assets to hold an additional layer of capital in the form of subordinated long-term bonds totaling at least 15 percent of consolidated assets.

2. If an institution were to fail, the long-term bondholders would be guaranteed at no more than 80 percent of the face value of the debt. As a result, banks would face pressure to shrink their balance sheets.

3. The bill calls for banks to be placed into receivership if credit-default swaps on the new long-term subordinated debt closes at an average of more than 100 basis points, or 1 percentage point, over 30 days. Such swaps don’t yet exist.

4. The extra layer of capital would be in addition to higher levels required as part of the Basel III international regulatory accords. The goal is to protect taxpayers from bailouts and equalize competitiveness between large and small institutions, which face higher costs of capital, Campbell said.

5. Under Campbell’s bill, if the price of a bank’s credit-default swaps increases more than 50 basis points, the Fed would have to take steps to assess the firm’s soundness.

6. His legislation also would repeal Dodd-Frank’s heightened standards for systemic institutions and its ban on proprietary trading, known as the Volcker rule.

I look forward to the thorough examination Campbell’s bill is likely to attract. My initial take: Yes, we want bondholders to take losses. Yes, we want to look to markets for signs of trouble. But Campbell’s heightened capital levels may not be enough as outlined in the Bloomberg piece. University of Chicago’s Eugene Fama, the father of the efficient market hypothesis, has called for financial firms to hold “lots more equity capital, much more than anybody’s talked about,” maybe 25%, maybe dramatically more.

I don’t think you can skimp on that if you are going to step away from even modest restrictions on activities. And Campbell isn’t proposing any additional basic equity capital. Basically, the Campbell plan seems to be a version of the novel plan sketched out by another University of Chicago economist, Luigi Zingales, in a must-read National Affairs essay:

Under this new system, banks would be required to hold two layers of capital to protect their systemically relevant obligations. The first layer would be basic equity — not much different from today’s standard capital requirement, except for the fact that the amount of equity required would be determined not by an accounting formula, but by a market assessment of the risk contained in the second layer.

That second layer would consist of so-called “junior long-term debt.” Being explicitly labeled “junior” means this debt would be repaid only after the institution has made good on its other debt, and so also means that it would involve more risk for those who buy it (therefore offering higher rates of return). Such debt would provide an added layer of protection to basic equity because, in the event the institution defaulted, the junior long-term debt could be paid back only after other (more systemically relevant) obligations have been repaid. Perhaps most important, because this layer of debt would be traded without the assumption that it would always be protected by federal bailouts, it would make possible a genuine market assessment of its value and risk — and therefore of those of the financial institution itself.

This is the crucial innovation of the approach we propose. The required second layer of capital would allow for a market-based trigger to signal that a firm’s equity cushion is thinning, that its long-term debt is potentially in danger, and therefore that the financial institution is taking on too much risk. If that warning mechanism provides accurate signals, and if the regulator intervenes in time, even the junior long-term debt will be paid in full. If either of these two conditions is not met, the institution may burn through some of the junior-debt layer — but its systemically relevant obligations will generally still be secure. In this case, the firm may suffer, but the larger financial system will be kept safe.

I should also add that Zingales, unlike Campbell, supports “the forced separation between investment banking and commercial banking” along the lines of Glass-Steagall. Campbell’s bill, and perhaps additional ones from other GOPers, may be given a boost when the Government Accountability Office releases its study — requested by Senator David Vitter, a Louisiana Republican and Senator Sherrod Brown, an Ohio Democrat — of the economic benefits that banks with more than $500 billion in assets receive “as a result of actual or perceived government support.” In any event, bipartisan support for BUBB seems to be gaining momentum on Capitol Hill.

7 thoughts on “GOP finally gets moving on shrinking Wall Street’s Too Big To Fail megabanks

  1. I’ve got a better way of accomplishing the same thing. Remove all but a minimal level of depositor insurance, along with any other implicit or explicit government guarantees for creditors, bondholders and trading partners.

    The absence of guarantees will force those who deal with a bank to diversify their holdings and exposure. Depositors would have no choice but to spread their money among many banks. Likewise, traders would not dare have more than a minimal amount of exposure to any single firm.

    There would be the same amount of overall financial assets in play, but spread over a much larger number of firms, thus reducing the impact any single firm could have, thus reducing the need for a bailout.

    • The big banks are already using the money from the fed to do risky investments.

      Break ‘em up. If you want to get rid of deposit insurance, be my guest. But the big banks need to be brought to slaughter.

      • What a stupid comment. If you don’t think banks are managing their risks, then you don’t understand banking. Breaking up banks would result in the systematic destruction of one of the few remaining industries where the US leads the world. Big banks are needed by big companies. The US turns back the clock on our banking system at great peril to the country’s economic dynamism.

  2. Too bad the Rs decided to pout rather than participate in Dodd Frank deliberations, as well as the ACA. There’d be less SAS on this site. (Ships that have Already Sailed.)

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