Re-Regulating The Banking System: What A Mess!

by: John M. Mason

Last week, in a jointly issued proposal, the Federal Deposit Insurance Corporation, the Board of Governors of the Federal Reserve System, and the Comptroller of the Currency, put forward a rule that would require the nation's largest banks to substantially increase their capital requirements. This is a proposal aimed reining in the "too-big-to-fail" banks.

The banks to be impacted by such a rule are those whose parent companies have more than $700 billion in consolidated assets. There are six of these banks, as of December 12, 2012. The basic thrust of the new rule: these banks would have to double the amount of capital they hold.

The idea behind this effort is that the "risk weighted" capital requirements that have been in use have not done the job. As Gretchen Morgenson writes in the New York Times, "This so-called risk-weighting approach was an abject failure."

The risk-weighting system is too subjective. The new rule is "blunt", but, as Morgenson explains:

It allows for much less subjectivity in analyzing risks on a bank's balance sheet. It also has the benefit of including more of a bank's off-balance-sheet holdings - like derivatives - in the capital calculation. That helps give investors a truer picture of a bank's financial position.

There are two immediate problems connected with the implementation of the new rule. First, it would tend to have a negative effect on bank lending. One way to meet the new capital requirements would be to shrink the balance sheet, and this could only be done by shrinking loan portfolios. Obviously, one could make the argument that this would not be desirable at this time because of the desire to have these banks making loans to spur on faster economic growth.

Second, the banks could attempt to raise the additional capital in the capital markets. But, having more capital on their balance sheets will reduce the banks' return on capital and, in all likelihood, increase their cost of capital. This would require the banks to increase loan rates, which would make US banks less competitive in world markets. This, bankers argue, would neither help produce more loans nor would it help United States banks maintain their competitiveness within the global economy.

Let me just say at this time that I am not against an increase in bank capital requirements. Also, I am not against moving back to a more aggregate capital target like the one proposed in the new rule. I have never been particularly fond of the risk-weighted capital measures, not only because of their subjectivity, but also because of the incentives set up by the regulators in the risk-weighting exercise.

Just one example of what can be done by governments using the risk-weighting scheme. In Europe, commercial banks were required to hold zero capital behind sovereign debt issues assuming that the sovereign debt was "risk free". Regulators continued to keep this assignment of capital long after it became very apparent that the debt was not, in fact, risk free. The did this to help undisciplined countries place their debt within their banking system under the assumption that if trouble did occur relative to the debt, that the governments would "bail out" the banks so that no losses would occur to the banks holding this "risky" debt.

The real point of this post, however, has to do with the current situation in the banking system. Policy makers are in a terrible position. Basically, the position policy makers find themselves in today is that they have no really good choices.

I wrote about this in my earlier post titled "Little Deal Activity." In this post I discussed the position of the Federal Reserve. The officials at the Fed have created a situation in which the market now expects that "for an extended period of time" the Fed will buy $85 billion of securities (US Treasury issues and Mortgage-Backed bonds) every month. That is the market expectation because Mr. Bernanke and others have been very explicit in trying to tell financial markets what they are doing.

The Federal Reserve is doing this, so we are told, in order to stimulate the economy and get the unemployment rate down. The problem the Fed faces, however, is that at some point, this quantitative easing is going to have to stop. To continue to purchase securities at this rate, over time, will cause an increase in price inflation despite the fact that there is no evidence of price inflation at the present time.

The crucial point is that the Federal Reserve will have to stop the purchase of securities sometime. When this happens, this will hurt! Interest rates will rise, etc..

Over the past few weeks, the markets have been told that the Fed is considering "tapering" these purchases. Officials at the Fed were takena back when the financial markets reacted abruptly and sent long-term interest rates rising. This response even brought out Mr. Bernanke to "explicitly" state that the Fed's intentions were to continue for quantitative easing for the near term.

Thus, Federal Reserve officials are damned if they keep up the securities purchases at the monthly rate of $85 billion and they are damned if they "taper" off from this rate. Because of the Fed's past actions, they have placed themselves in an almost impossible position.

My argument is that the governmental policy makers are finding themselves in such a position in other areas, the area of bank capital being one.

The credit inflation engaged in by the federal government, both led by Republicans and Democrats over the past fifty years or so, created an environment in which banks…as well as other organizations in the economy…took on more risky assets, financed more longer-term assets with short-term liabilities, increased financial leverage, and created a large amount of financial innovation. The government, the central bank, and the financial regulators all supported this environment of credit inflation.

This extended period of credit inflation exploded in 2007 and produced the severe financial crisis that we are still dealing with. As a consequence of this crisis, we got the Dodd-Frank Wall Street Reform and Consumer Protection Act…a hodge-podge of almost inoperable complexity. Now, we have the move back to another form of capital requirements.

But, in moving back to a requirement that banks' reduce their capital leverage, the regulators are threatening the very economic recovery they are attempting to stimulate. That is, they are caught between a rock and a hard place. Either the regulators act to protect the financial system or the act to keep banks lending. Damned if they do and damned if they don't.

One cannot avoid the analogy with habitual drinking. When an individual eventually comes to the time when a decision has to be made to continue the drinking or to take corrective measures, the dilemma arises. Each decision has painful consequences. One has to give up one's lifestyle and friends or one continues along the path that has been traveled with all the associated problems.

The federal government must now face the reality of the situation it is in. It cannot hope to re-establish "prudent" behavior in the banking system and the economy through increased regulation if it continues it overall policy of credit inflation. It was the government's policy of credit inflation, as discussed above, that originally created the incentives for increased financial leverage. To continue to stoke the fires of credit inflation and impose higher capital requirements will only create a situation in which the financial system will seek more and more ways around the new requirements.

The result, I believe, will be more growth in the "shadow banking" area! Is this a place where one should be looking investment opportunities?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.