Promises of a Dodd-Frank Act rollback sent bank stocks soaring following President Donald Trump's election. But FDIC Vice Chair Thomas Hoenig, widely reported as a potential Trump pick for the vacant vice chair of supervision role at the Federal Reserve, thinks any relief needs to come with higher capital requirements.
Lobbyists argue that current capital requirements are too high and express skepticism about the idea that regulatory relief should be contingent on Hoenig's preferred capital measure, the leverage ratio. JPMorgan Chase & Co. CEO Jamie Dimon, whose bank would have to raise the most capital under Hoenig's plan, wrote that "it is clear that the banks have too much capital" in the current environment in an April 4 letter to shareholders that called for regulatory relief.
"'If I can have regulatory relief and not have to increase my capital, that is what I'd prefer.' That's a 'have my cake and eat it too' kind of solution," Hoenig said in an interview. Hoenig proposes a system that would force banks to maintain equity equal to 10% of assets, compared to the current requirement of 5% for bank holding companies.
Hoenig's plan is in its early stages and would require legislative action. He said the central criticism so far is that the capital requirement is too high. Among the 585 bank holding companies in the U.S., the plan would require an equity raise of $507.22 billion. Just six bank holding companies would account for 80% of that tab, according to an analysis by S&P Global Market Intelligence.
The plan would also require the holding companies' depository subsidiaries and stand-alone depositories to reach the 10% level. But many of these — 3,083 depositories — already have that much capital.
The banking industry already faces numerous capital requirements and regulations brought on by Dodd-Frank. Bankers have complained that this baroque apparatus pushes up costs and restricts availability of credit, an important contributor to economic growth.
Hoenig envisions eliminating many Dodd-Frank regulations in favor of more capital and separation of riskier activities. Hoenig's plan would require banks to separate any "nontraditional" banking activities, such as securities investments or insurance underwriting, into a holding company that would need to be capitalized independently from "traditional" banking.
Hoenig said the separation of activities is important because it would ensure taxpayer funds only support traditional banking, which is critical to economic stability. When the taxpayer safety net supports riskier activities such as betting on derivatives, banks are able to operate with less capital than nonbanks, Hoenig said.
"We want to contain that moral hazard issue, and this is a method that does that and allows a broker-dealer to fail without bringing the entire system down," Hoenig said.
Some academics argue that capital is not an important factor in financial crises. A recently published research paper examined financial crises from 1870 through 2013, and found that higher levels of bank capital do not prevent crises. The economists, two from Germany's University of Bonn, one from the San Francisco Fed and another from the University of California, Davis, find that "if anything, higher capital is associated with higher risk of financial crisis."
"Risks are taken on the asset side of the balance sheet, and the problem is that leverage ratios don't tell us much about those risks," said Björn Richter, one of the authors, in an interview.
And former Federal Reserve Board Governor Daniel Tarullo, the financial system's unofficial "regulatory czar," criticized the idea of relying on a 10% leverage ratio in his April 4 farewell speech. Tarullo said the higher capital requirement would depress profits and encourage banks to take on more risk. Because a leverage ratio treats junk bonds the same as safer instruments, banks would load up on riskier, less liquid instruments, Tarullo said while advocating for continued reliance on risk-based capital ratios.
Hoenig accepts that higher leverage ratios will not prevent a crisis, but believes they will reduce the likelihood of a financial meltdown. He said more capital will also mitigate the effects of a downturn and ensure that more private capital absorbs losses before taxpayer money has to come into play.
Hoenig sees his proposal as a return to the fundamentals of capitalism. By eliminating liquidity provisions and many other Dodd-Frank requirements, his proposal allows bankers to run their operations as they see fit. And by requiring a greater amount of capital and a separation of riskier activity, the plan limits taxpayer involvement.
"Capitalism, by definition, is a system that has success and failure and through history economies have had downturns," Hoenig said. "It's just a matter of who absorbs the loss and how great the crisis has to be."
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