Good and Bad Bank Capital; Too big to fail gets a bigger backstop but more Basel confusion too.
Three years after President Obama signed Dodd-Frank, U.S. financial regulators have taken their first significant step toward protecting taxpayers from giant bank failures. Under a Tuesday proposal from the Federal Deposit Insurance Corporation, the eight largest U.S. financial houses would be required to hold more capital. This is a critical reform given that so many of the other rules that regulators have written place taxpayers in harm's way.</br></br>The political pressure to bail out banks will exist in any financial panic, no matter which party is in power, so the best way to prevent bailouts is to make banks less vulnerable to panics. One of the better protections is a heavy capital cushion at each of the too-big-to-fail banks. This means that private investors voluntarily contribute more equity now, so there are more resources to absorb future losses. Come the next crisis, there will be more room for banker and regulator error before taxpayers are forced to make involuntary contributions as in 2008.</br></br>Specifically, the FDIC and their regulatory colleagues at the Federal Reserve and Comptroller of the Currency proposed to increase the leverage ratio at giant bank holding companies to 5% from 3%, and to 6% for the insured deposit-taking banks inside these holding companies.</br></br>For either the parent companies or the FDIC-insured banks inside them, our preference would be to go north of 6%. Why not approach the capital levels that small finance companies without government backing are required by markets to hold, which can run into the teens? But the proposal is still a major step toward taxpayer protection and might require the giants to increase capital by close to $90 billion by 2018, or to shrink their balance sheets to operate more safely with the level of capital they hold today.</br></br>It's no surprise that the banks are unhappy, and they are warning that holding more capital means they will be sending less money out the door as loans. But that doesn't have to be the case. Banks can maintain their current lending and their current balance sheet bulk if they rely more on equity financing along with debt. And that represents a healthy step toward allocating greater risk to the investors who should be expected to bear it.