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The Seductive Simplicity of a New Banking Bill

By PETER EAVIS


We all want to live in a world where we can stop worrying about the banks. Would a tough new piece of legislation, introduced in the Senate on Wednesday, get us there?

Senators Sherrod Brown, Democrat of Ohio, and David Vitter, Republican of Louisiana, have two aims in writing their bank bill. They say they not only want to toughen the overhaul of the financial system, but also to simplify it.

Think of the senators as punk rockers reacting against the sophisticated progressive-rock scene of the 1970s. Sick of an ornate status quo, they have come out swinging with an uncluttered approach that many will find invigorating.

Before looking at what the bill would do, it’s interesting to note what it wouldn’t. The legislation doesn’t stipulate a maximum size for banks. And, strangely, it takes no big steps to force Wall Street operations out of the safety net that the Federal Reserve provides to banks in times of crisis.

Even so, the bill will of course face enormous resistance, and not just from the bank lobbyists who seem reflexively to oppose any measure to overhaul their industry. There are analysts who want to do more to rein in the banks, but who think the senators are naïve, or intellectually lacking, to think that today’s complex financial system can be made safer with their seemingly simple fixes.

They have a point.

The financial system will be safer than it was once the two big postcrisis overhauls are in place. Those are the Dodd-Frank legislation, passed by Congress in 2010, and the internationally agreed-upon banking rules known as Basel III.

These two efforts don’t set out to radically remake banks. They opt for a technocratic, pragmatic approach. Both take steps to make lenders more resilient to losses, and they introduce incentives to make riskier activities less attractive for banks. In an indirect way, they also try to keep banks from getting much bigger than they are today.

There’s one other important element to Basel III and the Dodd-Frank Act: they assume regulators are up to the task of monitoring big banks. That trust has been undermined by recent events. Regulators didn’t grasp the full danger of the gargantuan derivatives trades at JPMorgan Chase that led to big losses last year. Some analysts are questioning whether the Basel III figures put out by European banks reflect the true riskiness of their assets. And, of course, regulators did little to gird the banks ahead of the American housing bust or the European sovereign debt debacle.

And in a major way, the Brown-Vitter bill effectively sidesteps the need for reliable regulators. It simply says that all big banks would have to set up a buffer for potential losses – called capital in the industry – that is equivalent to 15 percent of their total assets.

Take TBTF Finance Corporation, a hypothetical bank that holds $300 billion of mortgages and $300 billion of government bonds. It would have to set aside 15 percent of $600 billion, or $90 billion, as capital under the proposed rule.

Basel III and Dodd-Frank also require certain levels of capital. But their capital calculations are heavily influenced by a practice called risk weighting. This says banks can hold less capital against assets that are perceived to have less chance of showing future losses.

At TBTF Finance, the Basel risk weightings might allow the bank to hold no capital against government bonds, and they might ask for 4 percent, or $12 billion, against the mortgages.

Basel III wouldn’t allow TBTF Finance to get away with just holding 4 percent capital. It could demand as much as 9.5 percent. But that 9.5 percent would be calculated on TBTF Finance’s total risk-weighted assets of $300 billion. That would mean the bank would have to hold $28.5 billion of capital, far less than the $90 billion under Brown-Vitter.

Clearly, under Basel, the banks have an incentive to get their risk-weighted assets down.

A lender with many different types of assets and a big trading operation will be doing thousands of risk-weighting calculations when setting its capital, some of which will involve complex computer models. Critics ask, How can regulators stay on top of everything? In addition, skeptics say that assuming some assets are less risky than others will end in tears, since it’s almost impossible to tell ahead of time where big losses will occur.

The Brown-Vitter bill sweeps all that aside. It would get rid of Basel III, and by insisting on 15 percent capital against all types of assets, it avoids stipulating which bank holdings are riskier than others.

But Brown-Vitter may have its own shortcomings. Granted, risk weightings may never accurately reflect what’s going on in the real world, but the newest proposal may fall into the same trap.

It treats all assets the same, an approach that may prove even more disconnected from reality. It is possible that the United States Treasury could default one day, which would make United States government bonds as risky as mortgages, but is it really right to build that unlikely occurrence into capital rules?

In fact, assuming all assets are equally risky could create perverse incentives, says Mayra Rodríguez Valladares, managing principal at MRV Associates, a firm that consults on Basel issues. Freed from risk weights, banks may be more inclined to make certain types of loans that have historically experienced big losses, like home equity mortgages. “Banks might invest more in high-yielding, high-risk assets,” said Ms. Rodríguez Valladares. “It’s totally inaccurate to lump everything into one category.”

Also, Basel III may end up being significantly stronger than its critics say. For instance, the world’s largest banks will be subject to a special surcharge. Ms. Rodríguez Valladares says there are discussions about whether to calculate this extra capital on total assets, not risk-weighted assets. Go back to TBTF Finance with its $28.5 billion of capital. Adding 2 percent of its total assets, or $12 billion, would take capital up to $40.5 billion.

That’s still less than half of what Brown-Vitter would require. Of course, it may be more closely matched to the risk of TBTF Finance’s assets. But if the risk weights are faulty, and TBTF Finance racks up crippling losses, the lender may burn through all its capital and fail. That could paralyze the financial system, weaken the wider economy and even prompt the government to bail it out.

The beauty of Brown-Vitter is that all that extra capital makes that awful outcome much less likely.

http://dealbook.nytimes.com/2013/04/26/the-seductive-simplicity-of-a-new-banking-bill/?ref=business&pagewanted=print