Saturday, April 6, 2013

Senators Brown and Vitter proposing that banks have capital levels they did in 1900

Bloomberg reports that Senators Brown and Vitter are proposing that banks hold significantly more capital.  The level of capital they are shooting for is the level that existed before the Fed was created in 1913.

Regular readers are not surprised that this is the time period chosen by the senators to set capital requirements.  Regular readers know that during this time period banks were subjected to market discipline and this is what the market determined was an adequate level of capital.

Banks were subjected to market discipline back then because they disclosed all of their exposure details.  Bankers knew that this level of disclosure was a sign of a bank that could stand on its own two feet and the failure to make this level of disclosure was to wave a big red flag announcing the bank had something to hide.

Today, however, banks are not subjected to market discipline because they are not required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

Senators Brown and Vitter try to get around this opacity by proposing complex rules.  Unfortunately, as Sheila Bair pointed out, banks are highly capable of gaming any simple rule, let alone a complex rule.

More importantly, Sheila Bair pointed out that in gaming capital rules, banks have mastered the fine art of presenting a different picture of their underlying strength, soundness and risk than actually exists.

This bears repeating:  in the absence of transparency, bank capital is deceptive (see Dexia's high capital right before it was nationalized).  It is dangerous to rely on bank capital showing anything useful due to the banks' and regulators' ability to manipulate bank capital rules.

Fortunately, Senators Brown and Vitter acknowledge that they do not have the votes to get their proposal passed.

As a result, they are freed up to focus on having the banks provide ultra transparency.  With ultra transparency, the Senators get the banks to hold the levels of capital the Senators want due to market discipline and avoid the banks gaming their safety, soundness and risk.

When the Senators focus on having the banks provide ultra transparency, they will find that the laws requiring this level of disclosure are already on the books.  They are part of the Securities Acts that require that market participants have access to all the useful, relevant information in an appropriate, timely manner so they can independently assess and make a fully informed decision.

The largest U.S. banks, including JPMorgan Chase & Co. and Bank of America Corp., would have to hold capital in excess of Basel III standards under a proposal being drafted by Senate Democrats and Republicans to curb the size of too-big-to-fail banks. 
The current draft of the legislation would require U.S. regulators to replace Basel III requirements with a higher capital standard: 10 percent for all banks and an additional surcharge of 5 percent for institutions with more than $400 billion in assets. 
Senators Sherrod Brown, a Democrat from Ohio, and David Vitter, a Republican from Louisiana, have said they intend to introduce the bill this month.... 
Karen Shaw Petrou, co-founder of Federal Financial Analytics Inc., a Washington-based consulting firm, said the proposal would return the banking system to a time before the Federal Deposit Insurance Corp. was set up to guarantee bank deposits. 
“I view it as a radical view of how American banks should be restructured that seems to disregard the role of the FDIC coverage, prudential regulation and the totally different structure of the 2013 economy,” Petrou said in an interview.
In the run up to the financial crisis, prudential regulation didn't work.

Common sense says that having failed once, there is no good reason to bet the stability of the financial system on its not failing again.

Fortunately, by simply requiring the banks to provide ultra transparency, there is no reason to have to rely on prudential regulation not failing again.  With market discipline, the banks will be kept on a much shorter leash with much higher capital levels.

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