Regulatory costs for banks have increased since the global financial crisis, but the reforms implemented did not solve the fact that the largest US banks are still “too big to fail” (TBTF).
This was one of the main takeaways from the 15th Anniversary Lehman Collapse Conference organised earlier this month by Better Markets, a US-based non-profit organisation. In particular, the post-2008 reforms increased capital relative to risk, but stopped short of requiring sufficient capital to minimise bail-out risks, academics argued during the conference.
Equity capital
“We need to focus on equity capital to mitigate the effects of TBTF going forward,” said Thomas Hoenig, former vice-chairman of the Federal Deposit Insurance Corporation (FDIC). There are advantages to judging capital using the leverage ratio, rather than the Basel capital standards which are currently being discussed by regulators, according to Mr Hoenig.
Leverage ratio takes the available capital and divides it by total assets. By contrast, Basel rules consider the ratio of capital to risk-weighted assets.
“Basel rules allow TBTF banks to shrink their balance sheet and thereby increase the perception of how much capital they have,” said Mr Hoenig.
The leverage ratio is a better indicator of a bank’s strength, he maintained. “It tells you how much loss-absorbing capacity you have before a bank gets into a liquidity crisis and insolvency.”
Global systemic banks rely on equity to fund an average of only 7% of their assets. Regional banks have ratios that are closer to 9%, while community banks have well over 10%, said Mr Hoenig. Most systemically important banks seem far more leveraged and less capitalised than all the other groups. “I think we need to remember that, since they are the systemically important banks in the economy,” he added.
Leverage ratio, while not perfect, is more likely to be enforced, not just by regulators but by investors and the public, he believes. “When you see the amount of a bank’s capital absorbing capacity shrink, the market and the public would get worried, and this would keep a greater degree of discipline in place,” he told the conference.
Balance sheet strength
Banks have been advocating for lighter capital requirements as a way to stay more competitive. “I think investors prefer stronger to weaker balance sheets,” argued Mr Hoenig.
The FDIC is insistent on counting long-term subordinated debt as capital despite equity serving a much greater stability purpose than long-term debt, he added. “Because there’s too little equity in the banks, the regulators are suggesting the banks hold more long-term debt. The choice is more debt or nothing rather than more debt or more equity might go with more equity,” he said.
Most systemic banks, for example, carry long-term debt as approximately 6% to 9% of assets, depending on the calculations. If they were required to fund themselves with an equivalent amount of equity in place of debt, these institutions might be less prone to failure in the first place.
Economists Martin Hellwig and Anat Admati found that capital leverage requirements of at least 20% to 30% of total assets would make the lenders stronger without hindering economic growth.
Silicon Valley Bank, which collapsed in March, had experienced massive asset growth before its collapse in March. “If they had equity capital requirements, investors would have suddenly been alarmed by the enormous capital calls they would have to face. And the bank probably would have grown much more slowly,” Mr Hoenig said.
Unfortunately, most jurisdictions and tax policies encourage debt over equity, which creates perverse effects, said Ms Admati.
Revolving door
The ‘revolving door’ phenomenon should also be tackled, making sure high-level officials within regulatory bodies do not shy away from passing impactful legislation for fear of endangering their future ability to find a job in the same private sector they are regulating.
While there are already some rules on how long a public official has to wait before accepting certain jobs, such provisions should be more strict, noted Gerald Epstein, founding co-director of the Political Economy Research Institute at the University of Massachusetts Amherst.
The problem is that most of the highest officials in regulatory agencies come from the private sector. “So you’d have to block them from coming to entry. They’re going to argue these people are the most knowledgeable, which is a very legitimate point. You have to make the regulatory industry its own industry,” Mr Hoenig suggested.
