Raise the Minimum Capital Ratio to Prevent 'Too Big to Fail'

by: Vernon Hill

The financial crisis has proven yet again (as if anyone should need further convincing) that U.S. financial institutions implicitly deemed “too big to fail” tend also to be too big to manage. That creates an unacceptable systemic risk. Citigroup (NYSE:C), AIG, Wachovia, Washington Mutual, and Bank of America (NYSE:BAC) all provide good examples of the bad things that can happen when an institution becomes so large that managements can no longer keep track of all the mischief going on.

The solution? I believe these institutions should be broken up, so that they can once more be effectively and prudently managed. That would reduce systemic risk, increase competition, and, in general provide better services to customers at a lower cost.

But might such breakups be effected? Well, the government might:

- Enforce the now-unenforced national deposit limits.

- Create an insurance fund with premiums and oversight for all major financial institutions.

- Or just order the breakup of the biggest banks.

But a better solution, I believe, would be to allow the market, not the government, to solve this problem. In particular, as institutions grow larger, regulators should take account of the growing risk they pose to the system by imposing higher capital requirements on them. For instance, once a financial institution passes, say, $100 billion in assets, its minimum tangible equity capital should be increased. Then as the institution keeps on growing, minimum capital levels should be steadily increased, as well. A $1 trillion bank, after all, is inherently more risky to the system than a $100 billion bank.

So, for instance, if the minimum equity for a $100 billion institution is 5%, its required minimum capital might rise by 20 basis points for every additional $100 billion in assets it adds. A $1 trillion bank's minimum equity would then be 7%, versus the base minimum of 5%.

Then the market would work its magic. As a bank’s minimum capital levels rose, its returns would fall—and its growth would slow. Management would then be motivated to spin off units—which would reduce the size of the institution, and make the spun-off units better, more focused competitors. As all this occurred, institutions would stay small and manageable—as would the risk they’d pose to the system overall.

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