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Hensarling's proposal reignites discussion on capital's effectiveness as a safety net

U.S. banks and thrifts could qualify to receive regulatoryrelief in exchange for holding an average 10% leverage capital ratio under Rep.Jeb Hensarling's Financial CHOICE Act, continuing the discussion over howeffective capital can work as a safety net as opposed to regulations.

The legislation is part of an attempt by GOP lawmakers toreform the Dodd-Frank Act and provide a market solution for too-big-to-fail.Under the bill, any bank, thrift or credit union with a minimum average 10%leverage capital ratio over the most recent four quarters and CAMELS rating of1 to 2 could opt in and be exempt from any federal law, rule or regulationaddressing capital or liquidity requirements and any rule that would allow theFed to object to a capital distribution.

Additionally, it would prevent any regulator fromconsidering if the financial institution poses a risk to the financialstability of the U.S. and if a merger or acquisition would result in a risk tothe U.S. financial system, among other things. The legislation would alsoreplace Title II, the orderly liquidation authority to wind down a failingmegabank, with a chapter in the bankruptcy code.

While policy analysts do not expect the bill to pass thisyear, several applaud Hensarling for introducing the proposal and continuingthe capital discussion. Many of the provisions in the bill were also in the RepublicanParty's platform for 2016.

Mark Calabria, director of financial regulation studies atthe Cato Institute, said Hensarling is trying to set the terms of debate aroundfinancial reform.

"I do think that concept of higher capital for lessregulation is something that Republicans are starting to coalesce around,"he said in an interview.

Advocates of the bill argue that holding a high amount ofcapital should be enough for banks to withstand another financial crisis.

"The Financial CHOICE Act rests on the belief that ahigh level of private bank capital is the most basic element in making a financialsystem healthy, resilient and reliable for economic growth," Hensarlingsaid at a House Financial Services Committee hearing July 12.

The bill would require a higher capital buffer than requiredunder Dodd-Frank or Basel III, Hensarling noted.Lawmakers argue that no bank with a leverage ratio of 10% or more failed duringthe 2008 financial crisis. An analysis from S&P Global Market Intelligencefound of the 521 bank failures since 2007, only two had a leverage ratio above10% in the quarter before it failed. Only 34 had a leverage of more than 10%one year prior to failure and 10 two quarters prior to failure.

John Allison, former CEO of BB&T Corp., testified at the hearing that banksshould be allowed to fail. Getting rid of regulation and letting banks opt tohold more capital would create market discipline, he argued.

But some industry experts say relying on one form of capitalis too simplistic.

"We all long for simpler time, but I'm not sure thatsimpler times were as good as we thought they were," said Oliver Ireland,a partner at Morrison & Foerster.He added that the bill would encourage banks to keep riskier assets and woulddiscourage liquidity. Calabria added that what causes a financial crisis is notoften thought of as a crisis beforehand.

Justin Schardin, director of financial regulatory reform forthe Bipartisan Policy Center, said that while GOP lawmakers point to howregulators misjudged risk rating prior to the crisis as an argument for asimple leverage ratio, everyone else missed it, too.

"We shouldn't expect regulators to have perfectforesight, but we shouldn't expect that market discipline is always going towork either," he said.

Federal Reserve Chair Janet Yellen does not think banksdesignated as systemically important financial institutions should be givenregulatory relief in exchange for more capital, she the House Financial ServicesCommittee on June 22. The Fed is looking into a simplified capital structurefor community banks, she added.

GOP lawmakers have cited FDIC Vice Chairman Thomas Hoenig'sresearch as the basis for the 10% leverage ratio requirement, but .

Hoenig's own proposal for regulatory relief differs from theGOP legislation in that it would give regulatory relief to banks with anequity-to-assets ratio of at least 10% and few derivative positions, amongother things.

Jim Nussle, president and CEO of the Credit Union NationalAssociation, said in an interview that while 60% of credit unions in hisorganization hold at least a 10% leverage ratio, capital is a "preciouscommodity" and many credit unions are conservative about how much capitalthey hold.

"The only current way most credit unions raise capitalis through retained earnings, so we don't have a lot of the other alternativetools in the toolbox to raise capital," he said.