Industry News

A Persuasive Plan to Protect Banks and Taxpayers


Jack Willoughby | Monday, March 27, 2017

Barron's

Anticipation of a push to remove regulations has helped send bank stocks soaring nearly 25% since the election of Donald Trump in November. It has also encouraged economists and analysts to upgrade their forecasts for U.S. gross-domestic-product growth.

The variety of rollback proposals has included some big deals—such as gutting the Dodd-Frank Wall Street reform legislation, and shuttering the Consumer Financial Protection Bureau. But there are more-modest rollbacks, too, and it's one of these that's the most practical we've heard. It comes from Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corp. His straightforward idea would be to provide banks with needed relief from costly regulatory tests and red tape while renewing taxpayers' trust in the U.S. financial system.

Rather than a wholesale removal of regulations, the former president of the Kansas City Federal Reserve Bank would like to see traditional banking activities like deposit taking and lending partitioned from nontraditional activities like investment banking. Hoenig would then force banks to carry bigger capital cushions on nontraditional services. A bank's private owners would have to use their own equity to "absorb the shocks," says Hoenig.

By Hoenig's estimation, taxpayers have already effectively subsidized the top 10 U.S. banks and insured depositories to the tune of $400 billion. At the same time, Dodd-Frank and the CFPB are too cumbersome. The rules have served to "enshrine" the notion that some banks are too big to fail and require assistance in dire circumstances. By partitioning a bank's most essential activities and requiring private capital for nontraditional activities, "too big to fail would be on its way to being addressed," Hoenig told bankers at a conference in Washington, D.C., on March 13.

Nontraditional services would be separately managed, and exist apart from the insured bank. Capital ratios could not be less than the 8% currently carried by nonbank financial-services providers, which don't have access to insured banks. The nontraditional services would come under an intermediate holding company subject to the normal bankruptcy process—without affecting the traditional bank.

Tracking shares issued by the parent would cover these nontraditional operations, providing insights into the performance of nontraditional assets and reflecting their value. That would help insulate insured depositories from potential losses.

Nontraditional affiliates would be subject to independent liquidity requirements to limit access to the public safety net. Strict qualitative and quantitative limits would keep the financial affairs of both traditional and nontraditional operations separate.

The biggest banks need to be better capitalized—at 10% of tangible assets versus 5.75% currently—to provide a buffer against contagion. Similarly, the Federal Reserve could set the capital levels for affiliates based on the perception of public-safety risk.

Hoenig sees today's tangible equity cushions as perilously low. Even with a bailout, the big banks experienced losses equal to 6% of assets in the 2008 crisis. They entered the crisis with average levels of only 3%. He doesn't buy the complaint that high capital levels for megabanks hamper lending and represent an economic drag. "Insured banks with higher levels of tangible equity are more likely to lend through economic cycles, including downturns, which helps sustain economic growth over the long term," he says.

Restructuring and extra capital buffers would allow for a significant reduction of regulations. Dodd-Frank stress-testing, Comprehensive Capital Analysis and Review, Title II, and the banks' Living Wills could all be done away with or simplified, and the Volcker rule could be eased. Separately managed affiliates could own or sponsor private-equity firms or operate hedge funds. Reforms, he says, "must be founded in capitalism that permits failure and improves economic efficiency and growth while maintaining the safety and soundness of the economic and financial system overall."

The trick is making sure that the largest banks operate at capital levels where owners—not taxpayers—cover the cost of inevitable failures. It's a test of political will.

This article was licensed through Dow Jones Direct.

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