Calm Your Financial Fears

Would reforms to the Dodd-Frank Act, the legislative response to the last financial crisis, open the way to another crisis as some suggest? Not necessarily.

First, some background. In a new study, I look at how financial holding companies responded after bank regulators finalized the so-called "recourse rule" in 2001. Financial holding companies are the parent corporations of most banks. I found that the largest financial holding companies that were in the business of pooling debt and selling assets backed by that underlying debt, or "private label" securitizations, increased their holdings of those same assets, perhaps to signal that they stood by the product.

The rule change favored holdings of highly rated securitized assets by lowering financial holding companies' capital requirements on the highest rated assets. Think of capital as a measure of a financial holding company's net worth. Higher capital requirements mean a financial holding company relies less on short-term funding, and more on equity (or long-term debt) to fund asset holdings. Financial holding companies holding more highly rated, "private label" securitized assets experienced greater increases in default risk after 2008.

Parts of the Dodd-Frank Act, passed in 2010, effectively reversed the recourse rule. Sections 606 and 607 changed the language concerning financial holding company capital requirements from being "adequately capitalized" to being "well capitalized." Section 939 eliminated statutory references to ratings in, among other things, capital requirements.

Since little else in Dodd-Frank addressed causes of the crisis, as long as Dodd-Frank reforms address what sections 606, 607 and 939 do, there's no reason to fear a repeat crisis.

The Financial CHOICE Act of 2017, introduced by Rep. Jeb Hensarling, R-Texas, chairman of the House Financial Services Committee, and a proposal by Federal Deposit Insurance Corporation Vice Chairman Thomas Hoenig aim to keep what Dodd-Frank got right, while addressing the added regulatory burden it places on banks. With the release of its preliminary report for bank reform, the United States Treasury Department has now weighed in on the debate.

So let's review the options.

The act offers financial holding companies a choice: Financial holding companies funding their asset holdings with at least 10 percent equity capital can avoid other Dodd-Frank regulatory burdens. Those with less capital face Dodd-Frank regulatory burdens. Concerns exist that the largest financial holding companies prefer lower capital and keeping the regulatory burdens, since regulations keep out competitors.

Enter Hoenig's proposal, which reworks the traditional financial holding company structure. "Traditional banking activities," such as loans and deposit-taking, would get fenced into a bank intermediate holding company. Other activities such as market making, trusts and underwriting would get fenced into separate intermediate holding companies. The parent and the bank intermediate holding companies would each have to ensure that they're funded with at least 10 percent equity capital; the other intermediate holding companies would have similar equity capital requirements. As with the Financial CHOICE Act, higher capital replaces regulation, but the regulated entities would have no choice.

The best summary of what's right (and wrong) with the Treasury report's view regarding bank capital appears on page 49: "The current capital and liquidity regime could be made less costly by reducing its excessive conservativism, opacity, and duplication." The second and third characterizations may be right, but the first is wrong.

On excess conservatism, the Treasury report suggests that banks are better capitalized now than since the crisis because average Tier 1 capital ratios have risen to nearly 14 percent. Tier 1 capital ratios, whose origins and shortcomings I've discussed elsewhere, serve as the current key regulatory measure of bank capital.

Hoenig's "Global Capital Index for U.S. Global Systemically Important Banks" confirms the 14 percent value, but also shows that if measured according to the Generally Accepted Accounting Principles that U.S. financial holding companies apply, the average falls to only 8 percent, not much higher than Citigroup's 6 percent ratio just before the crisis.

On opacity, the Treasury report correctly identifies the Comprehensive Capital Analysis and Review, or "CCAR," exercise as an opaque process, after all those arguing for opacity suggest that banks would not develop their own methods to assess their risks if the process were not opaque.

On duplication, the Treasury report correctly points out that requiring banks to compute both the standardized and advanced approaches for capital requirements is redundant.

In response to a recent op-ed, Hoover Institution Senior Fellow John Cochrane claimed that the last financial crisis would never have happened if banks had been funded with at least 20 percent equity capital. That's also consistent with sections 606, 607 and 939 of Dodd-Frank, and best summarizes the key principle that should underlie any Dodd-Frank reform proposals.