Certainly Washington intervened massively to prop up megabanks during the financial panic of 2008. The perception that taxpayers ultimately stand behind the banks’ balance sheets persists in spite of the Dodd-Frank financial reform bill. Consequently, the banks enjoy cheaper funding than they otherwise might, enabling them to outcompete smaller banks, and thus get bigger still.
Now come two senators, liberal Democrat Sherrod Brown (Ohio) and conservative Republican David Vitter (La.), with a left-right fusion bill aimed at this unhealthy situation. Its core provision requires that all banks with more than $500 billion in assets hold a safety cushion of at least $15 in equity capital for every $100 in assets. The bill would not only require more and better capital but also limit the “risk-weighting” of assets, on the grounds that banks can manipulate such calculations to make their balance sheets seem artificially safe.
This would likely force the Big Four to spin off much of their current business, defusing systemic risk that Mr. Brown and Mr. Vitter believe they now pose.
Big banks protest that they have already deleveraged more than their critics generally admit and that shrinking them will restrict credit, thus slowing economic growth. Both are plausible points, though the latter needs a grain of salt: The Brown-Vitter bill would inevitably reduce megabanks’ return on equity, to which executive pay has historically been linked.
The bill would put the United States at odds with the international bank regulation process known as Basel III. Basel III is less aggressive about capital requirements but has the advantage of being a global approach to a globally interconnected sector.
Big banks’ reliance on debt financing reflects not only the too-big-to-fail phenomenon but also the favored treatment of interest payments under the U.S. tax code. Forcing them to shift to equity would therefore increase their tax burden, a real cost that could be passed on to customers.
In a financial catastrophe, even a $500 billion bank holding 15 percent equity might go under, threatening such painful economic fallout that the government would want to bail it out. In that sense, Brown-Vitter would eliminate “too big” more certainly than “too big to fail.”
In short, we doubt Brown-Vitter will be that rare piece of legislation with no trade-offs or unintended consequences. Still, it proposes a clear, understandable rule in a regulatory area currently characterized by complexity and confusion. That helps to keep the too-big-to-fail debate going, and headed in the right direction.