The New Republic

[Guest post by Noam Scheiber:]

The morning after the Senate approved its financial reform package last week, I wrote a piece suggesting that while the legislation should mitigate the too-big-to-fail (TBTF) problem, it isn’t likely to solve it. Not long after, I spoke with a Treasury official who protested that I was being uncharitable. After mulling over our conversation, I’ve decided he was right—I was a bit uncharitable. Perhaps more importantly, my critique was a little muddled, which made me sound more critical than I actually am. So let me take another crack at it.

To review: The bill emerging from Congress does take some concrete steps to address TBTF. If nothing else, it gives the government so-called “resolution authority”—that is, the power to unwind failing megabanks—which leaves bank creditors more vulnerable to losses in the event of a collapse. That should make these people somewhat warier of lending money to big banks, which should rein in the banks’ size and risk-taking. But due to various practical complications, I wasn’t convinced—and still am not—that resolution authority does the job in itself.

There are other ways to deal with TBTF, of course. The government could simply break up the banks. Or, because one reason banks get big is that they don’t pay the full social cost of their bigness (namely, the risk that they’ll collapse and require a bailout), we could just tax big banks enough to offset that implicit subsidy. Another way to do this would be to force big banks to hold a lot more capital, which reduces profitability and is therefore roughly equivalent to a tax. (More capital also means a bigger cushion against losses, which makes it less likely that a bank will fail and need government help.)

In my piece, I lamented that the legislation moving through Congress doesn’t really do any of these things. The Senate rejected an amendment to break up the biggest banks; a permanent bank tax was never really on the table. And while the bill tells regulators to force banks to hold more capital, it doesn’t specifically prescribe a new, higher amount. Or, put differently: The law doesn’t say companies of size X must now hold Y amount of capital. It tells regulators to go off and figure out what Y should be.* The concern here is that regulators didn’t do a great job figuring things out in the run-up to the crisis; future regulators could stumble the same way.

That’s where the Treasury official chimed in.

Treasury believes the new rules on capital will be more effective if regulators make them than if Congress had filled in the details itself. This is the case for a variety of reasons. For one, banks employ lots of smart people whose job it is to figure out how to fudge the laws Congress passes. If Congress says banks have to hold Y level of capital, these geniuses will come up with reasons why something we didn’t previously think of as capital should now count as capital. Or why an amount that used to be thought of as half of Y should now be considered equivalent to Y. (Sounds hard to believe, I know. But these things happened a lot during the bubble years.) Relatedly, we may discover in a year or two that Y is much too low, so that the financial system won’t be very safe even if banks are obeying the law. The beauty of giving regulators a freer hand, the thinking goes, is that they’ll be agile enough to deal with these developments.

Finally, Treasury argues that the logic of the new capital requirements will be to ratchet up over time. One reason is that the bill creates an oversight council—composed of the Treasury secretary, Fed chairman, FDIC chairman, and a handful of other appointees—to watch over the bank regulators (namely, the Fed). If the council thinks big institutions need more capital, it can advise regulators to make it happen. But the council can’t ask them to lower the requirements. So there’s an asymmetry here that favors increasing toughness.

Now this doesn't solve every problem: It’s not hard to imagine future regulators falling asleep when firms start evading the rules they (or their predecessors) put in place. Nor is it hard to imagine an oversight council stocked with laissez faire-minded appointees who don’t see any problem with this. But I think you can make a case that, for any rough target on capital, you do about as well relying on regulators to come up with the number as you do having Congress set it in stone.**

But here’s the catch: That target is qualitatively, not just quantitatively, important, because different levels of capital serve different purposes. That is, you could presumably set one level that would make it unprofitable for the biggest banks to get bigger, but wouldn’t really incentivize them to get smaller. And you could set another, higher, level of capital that would give the biggest banks an incentive to shrink. (For example, you could say that banks with more than $1 trillion in assets—there are a few of them—have to hold way more capital than banks with less than $1 trillion, which would make it worth the banks’ while to get under the $1 trillion threshold.)

To be sure, I’m glossing over a lot of nuances here. To take one, we may not care so much about size per se as we do about a bank’s higher-risk activities, which we want to scale back.*** But the basic idea is that one approach would make the system safer by forcing banks to hold more capital while essentially preserving the status quo on size (or maybe bringing about some shrinkage at the margins). The other approach makes the system safer by eliciting a change in its basic structure. In that way, it’s much more like a breakup.

The legislation moving through Congress basically follows the first approach. And my view is that it’s about the best you could hope for short of structural changes. (Which may mean it’s the best you could hope for period, given the difficulty of structural change.) But if you’re asking what would make me sleep better at night—big banks with more capital or smaller banks engaged in fewer risky activities—I’d still go with the latter, for the simple reason that it’s less vulnerable to human fallibility.

*There are two amendments—one in the House by California Rep. Jackie Speier, and one in the Senate by Maine Republican Susan Collins—that do this to varying degrees. But they seem unlikely to make it into the bill the president signs, at least in something resembling their current form.

**You could obviously have Congress set a number and then give regulators the freedom to increase it later on. But I’d guess it’s tougher to update a number Congress hands down than one a regulator comes up with. It’s easy to imagine the banks complaining to a regulator who wants to raise their capital requirement that Congress would have set it higher had it wanted it to be higher.

***There’s a nod at this in the Senate bill, but it’s pretty weak—a loophole-riddled version of the so-called Volcker Rule. An amendment by Senators Carl Levin and Jeff Merkley, which the administration and congressional Democrats supported, would have given this provision some substance. But the Republicans blocked a vote on it.

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