One of the responses to the financial turmoil of 2008 was new legislation and regulation intended to prevent such a disaster from recurring. These measures include the Dodd-Frank Act of 2010 and the third international accord from the Basel Committee on Banking Supervision of 2010-11. But today, there are powerful voices seeking to amend or overturn these measures. President Donald Trump said on December 12:
We have to end Dodd-Frank…. The head of the banks, they're petrified of the regulators….I mean, unless you have 5 time what you want to borrow, they don't lend you any money. They're afraid to loan people money and those are the people that should be able to borrow.
And Representative Patrick McHenry (R-NC), Vice Chair of the Financial Services Committee, wrote on January 31:
Agreements like the Basel III Accord … turned into domestic regulations that forced American firms of various sizes to substantially raise their capital requirements, leading to slower growth here in America.
Here I review the motivations for Dodd-Frank and Basel III and some of the proposals to amend or replace them.
The business of banks is borrowing short and lending long. A bank obtains funds from customer deposits and uses them to make longer-term loans. If the bank has to sell the loans at a loss, where does the money come from to pay back the depositors? The answer is that the bank's loans should only be funded in part with customer deposits or short-term debt. The rest of the funds that the bank loans out should come from equity that the owners of the bank themselves contributed. As long as the owners' equity is sufficient to cover any potential losses, the bank's short-term obligations can always be honored.
The ability of the bank to repay its short-term debt is of interest not just to the bank's depositors and creditors, but also to all of us innocent bystanders. When the ability of major financial institutions to pay back their short-term debts comes into doubt, the result is that nobody wants to lend to anybody. We can then see a fire sale as institutions try to dump their risky assets to raise cash. That's the essence of the financial turmoil in the fall of 2008, which unquestionably was a key factor that made the broad economic recession so severe.
If we require financial institutions to have enough equity to cover possible losses, no taxpayer dollars would ever be needed to bail the banks out. The owners of the bank will be the only ones hurt if the bank makes bad loans, and nobody has to panic that the bank can't pay back its creditors.
A key goal of Basel III was to strengthen equity requirements. Basel III requires banks to have Tier 1 capital (basically the banks' common and preferred stock equity) equal to at least 6% of risk-adjusted assets, up from the 4% required under Basel II. Tier 1 capital also has to be at least 3% of a broader measure of assets plus off-balance-sheet exposures. There are a number of other capital and liquidity requirements of Basel III. The Federal Reserve has implemented an even tougher set of standards for large U.S. financial institutions.
And there were a number of regulatory changes in Dodd-Frank. Among the most important were requirements for the largest banks to draw up "living wills," or detailed plans for how the institution could be orderly liquidated if it starts to fail, and procedures that gave regulators authority to block dividend payments if equity appears to be inadequate to handle potential stresses on the balance sheet.
If these changes are undone, what would replace them? The Financial Choice Act, introduced by Representative Jeb Hensarling (R-TX) last year, would exempt banks from these and other regulations if they maintain a simple capital requirement of 10% of "leverage exposure," which is conceived as in Basel III to include off-balance-sheet exposure in addition to on-balance-sheet assets. The theory appears to be that if the bank has sufficient equity, then the risks are all on the bank's owners, and further regulation is largely unnecessary. But as always, the devil is in the details. How exactly will this ratio be calculated? If it is the simple ratio of Tier 1 capital to risk-adjusted assets, the major U.S. banks already are well above the 10% threshold. If it is the ratio as calculated under Basel III, the major banks would have to raise hundreds of billions in new equity to reach 10%.
|Self-reported Basel III ratio|
|Bank of America (NYSE:BAC)|
|Bank of New York Mellon (NYSE:BK)|
|Goldman Sachs (NYSE:GS)|
|JPMorgan Chase (NYSE:JPM)|
|Morgan Stanley (NYSE:MS)|
|State Street (NYSE:STT)|
|Wells Fargo (NYSE:WFC)|
Data source: FDIC
And how will this little detail end up getting resolved? Perhaps Representative Hensarling hopes for a libertarian, self-enforcing framework that would use numbers like those in the second column above. But the statements by President Trump and Representative McHenry quoted above suggest they would be happier if the calculation was closer to the first column. And presumably it is administrators appointed by the president who would end up interpreting the rules about off-balance sheet items.
There is a definite tradeoff between promoting financial stability (which calls for high capital requirements) and encouraging banks to make risky loans. Particularly now that the U.S. is nearing full employment, I would think we want to be paying more attention to the former goal.
I do not deny that there are some aspects of Dodd-Frank that could be improved. But I also know that the level of regulation in 2006 definitely needed to be improved.
For more discussion of Representative McHenry's concerns about Basel III, please see Cecchetti and Schoenholtz.
Editor's note: This article was originally published on February 19, 2017, by James Hamilton here.