New Banking Rules Emphasize Stability

By Binyamin Appelbaum
Washington Post Staff Writer
Saturday, September 5, 2009

The Obama administration is moving forward with one of its most fundamental financial reforms, a plan to constrain the growth and risk-taking of giant banks and other firms.

The plan is the keystone of the administration's broader effort to reverse a generation of public policy that strongly favored the emergence of behemoths such as Citigroup. The government now wants to pressure such firms to become smaller, more stable and less likely to need the sort of massive federal bailouts that have defined the current economic crisis.

Regulators would require all financial firms to hold larger capital reserves against unexpected losses. The largest firms would be forced to set aside even greater reserves, the rough equivalent of requiring a racehorse to carry more weight.

Administration officials say that large financial firms can offer important benefits to customers, such as the convenience of a one-stop shop for multiple services, but they want to rein in the excesses that produced a global recession.

They acknowledge that in reducing the risk of catastrophe, they may also limit the good times. Banks could pass on increased costs, for example, by making loans more expensive and harder to get.

The Treasury Department released a conceptual outline of the proposal Thursday, and it is scheduled for discussion this weekend at the Group of 20 meetings of world leaders in London. Unlike other key parts of the president's reform agenda, the new standards would not require approval by Congress.

"While seemingly technical, the policy will have profound impact on U.S. financial-services firms, especially since much in it can and will be implemented without legislation," said Karen Shaw Petrou, managing partner of Federal Financial Analytics, which tracks regulatory issues for clients in the financial industry.

The fall financial crisis nearly spun out of control in large part because firms lacked sufficient reserves to absorb unexpected losses, experts and regulators now generally agree. The Treasury has invested almost $200 billion in banks to shore up their capital, offering a basic measure of the scale of the shortfall.

The lack of reserves -- and the lack of clarity about just how thin those cushions were -- panicked investors and customers, sending some firms into fatal tailspins. Others survived, but cut back sharply on lending as they diverted money to rebuild their cushions, choking the broader economy.

A bank's capital is a fund raised from sources that do not need to be repaid, such as money raised from the sale of common stock. Regulators have long dictated the size of a reserve as a basic means of exerting control over banks. They also restricted the kinds of loans and investments a bank could make. Beginning in the 1980s, regulators gave banks increasingly broad freedom to pursue new activities, relying ever more heavily on reserve requirements. As banks took more risks, they were supposed to set aside more money.

During the housing boom, firms figured out how to conceal risks, and regulators largely turned a blind eye. Reserves at many financial firms shrank as risks ballooned.

The administration has proposed several fundamental reforms to ensure that firms hold sufficient capital in the future, limiting the risk of a similar crisis.

One element targets the firms that pose the greatest risk to the broader economy. The Treasury has proposed requiring firms to hold relatively larger amounts of capital based on four key characteristics: the size of the bank, the scale of its bets, the sources of its funding and the extent of its ties to other firms.

The formula reflects a judgment that the greatest risks to the financial system and the broader economy are posed by large firms that take short-term loans to make large bets with lots of other financial firms. Lehman Brothers, which collapsed last fall, was such a company.

The administration also wants to impose a new capital requirement that is not tied to risk. In general, the capital that a firm must hold is based in part on an assessment of the risk of its investments and other commitments. Firms have proved adept at circumventing those rules, however, so the administration wants to impose a minimum requirement based on the amount of investments, no matter how small the risk of loss is made to appear.

A third element would require banks to demonstrate for the first time that they have adequate access to funding for their operations, the equivalent of making sure that a city has enough water to survive a siege. The evaporation of what bankers call liquidity was an important factor in the failure of several large financial firms during the crisis.

Key details remain undecided, such as whether to assess firms on a sliding scale or whether to create tiers, imposing the same requirements on every firm in a given tier.

The industry, chastened by the crisis, has generally accepted the necessity for more rigorous rules. But the details of the administration's plan -- particularly the size of the penalties assessed on large and risky firms -- are likely subjects for intense debate.

Scott Talbott of the Financial Services Roundtable, a group that represents the largest financial firms, said the group supported additional capital requirements focused on risk, so as not to hobble large firms.

"Those who argue that big is bad are misguided," Talbott said. "You need large financial institutions in this global economy, or you won't be able to service the needs of large multinational corporations."

While the plan itself does not require legislation, its success depends in part on the passage of the administration's broader plan for financial reform, which calls for a systemic risk regulator. Without such an authority, imposing additional requirements on banks could simply squeeze financial activity outside the scope of regulation.

The administration also needs the support of banking regulators. One of those regulators, Sheila C. Bair, chairman of the Federal Deposit Insurance Corp., endorsed the idea of increased capital requirements in an article in the September issue of a journal published by the Banque de France.

"It is now clear that the international regulatory community relied too heavily on the supposed benefits of diversification and modern risk-management practices when setting minimum regulatory capital requirements for large, complex financial institutions," Bair wrote.

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