In 2010, Rep. Keith Ellison (D-Minn.) wanted a leverage ratio written into law. Dodd-Frank didn't include that. (Alex Brandon/Associated Press)

In early 2010, during the debate over the construction of the financial reform bill that would become Dodd-Frank, Rep. Keith Ellison (D-Minn.) received a curious letter from then- Treasury Secretary Tim Geithner. Everyone thought that increasing the amount of capital banks were required to hold would be an essential part of financial reform--the question was how to do it. Ellison had written the Treasury department to ask whether Congress should write a specific leverage ratio into the bill itself.

Geithner responded that “[p]lacing fixed, numerical capital requirements in statute will produce an ossified safety and soundness framework.” Even worse, Congress writing a specific requirement into the bill would remove the flexibility that Treasury and banking regulators would need to negotiate in the then upcoming Basel III agreements. Leave it to the regulators, said Geithner, which is what Congress did.

It’s been three years since then and regulators are now implementing the new capital rules. However, the capital requirements are coming under increasing criticism, both for the level of capital and the way banks are allowed to calculate it. And one group in particular is demanding more action: members of the Congress who left it to the regulators in the first place.

Specifically, Sens. Sherrod Brown (D-Ohio) and David Vitter (R-La.) have introduced their bill that would dramatically increase capital requirements for banks by writing them explicitly into the law. Wonkblog covered the nuts-and-bolts of a leaked version of the bill here, and the current version of the bill is similar in the basics. This bill will inform post-Dodd Frank financial reform, so let’s discuss the context for this bill rolling out.

How Has Dodd-Frank Gone?

Sen. Christopher Dodd (D-Conn.), center, and Rep. Barney Frank (D-MA), right, both retired now, celebrate the signing of their financial reform bill in 2010. (Pablo Martinez Monsivais / AP)

First off is understanding how Dodd-Frank has gone. One narrative argues that the bill’s regulations are getting picked apart during the rule-writing process. Two recent, excellent longreads of this narrative come from Haley Sweetland Edwards of the Washington Monthly and Gary Rivlin of The Nation.

On the other side, some argue that Dodd-Frank has ended Too Big To Fail. The process known as resolution authority, which would allow FDIC to take over and wind down any large financial firm, is coming together well enough that no financial firm is exempt from failure. Imposing higher capital requirements would then be a dangerous, costly and unnecessary addition to financial reform. Mary John Miller, under secretary of the Treasury, has given speeches to this effect, as well as financial industry lobbyists. (As David Dayen noted at The American Prospect, sometimes the same arguments and data points are being deployed by both the Treasury and the financial industry.)

One should note that saying higher capital is unnecessary because the FDIC can fail firms is like saying that since cars have airbags there’s no need for speed limits. There’s no contradiction between these two arguments at all. Former FDIC chairwoman Sheila Bair, for instance, has recently argued that resolution authority is coming along well in ending Too Big To Fail while also calling for a much higher 8 percent leverage ratio. These regulations complement each other.

Those in favor of a higher capital requirement often rely on arguments that there’s a “subsidy” in the cost of funding large banks receive. Though that argument is important, it isn’t necessary for something like Brown-Vitter to pass, because there are many other reasons we’d want to bump up capital requirements.

Higher capital also acts as a backstop on other problems that we can’t anticipate. Whatever the dubious financial innovation of 2043 is going to be - asteroid-backed holographic securities? - more capital will make that system more resilient. This puts less pressure on having to get every other regulation perfect, or keep a system so dynamic it anticipates every problem.

It tightens Dodd-Frank by increasing already existing requirements, rather than bringing in a whole new regulatory infrastructure. One of the key innovations of Brown-Vitter – directly ensuring that capital requirements are graduated by size – allows for banks that genuinely benefit from being so big to be able to do so. For a bank that is failing, more capital gives regulators more time to intervene with these new resolution authority problems, crucially helping an untested solution. And it also helps with problems in estimating capital.

Two types of capital ratio

Sens. David Vitter (R-LA), left, and Sen. Sherrod Brown (D-Ohio) introduce their financial reform bill this year. (Win McNamee/GETTY IMAGES)

The final Brown-Vitter tosses out the implementation of Basel III. It’s not clear why it does this, as Basel III has a lot of important parts. There are liquidity requirements designed to prevent short-term runs. There’s a capital buffer specially designed to prevent dividends and bonuses if banks start to run low on capital. It’s a major loss to financial reform to just give that up all.

But the big debate here is how to determine what counts as capital. There are two general approaches to capital requirements. One approach “risk-weights” the assets, which means you can hold less capital for assets that are deemed to be less risky. The other approach doesn’t adjust for risk, and has a simple “leverage ratio.” Basel III has both, but Brown-Vitter would toss out risk-weighting and have a much higher leverage ratio.

If that’s not clear, imagine a bank choosing between two portfolios that are the same size, one full of risky assets and another that is full of safer assets. A leverage ratio would require the same capital for both. This means, as many are starting to point out, that only having a leverage ratio could actually mean riskier lending. The counter-argument is that risk-weighting incentivizes banks to hide risk or juke their statistics, giving everyone a false sense of security. Risk-weighting was letting the market decide capital, as it was believed that banks’ internal monitors were better than the blunt, simple categories of leverage ratios. That argument is less popular now that it was in the go-go finance era.

It would be easy to continue to use both, but at a higher rate. The biggest problem with Basel III is that the leverage ratio, currently at 3 percent, is far too low. As Marcus Stanley of Americans for Financial Reform told me, “the 3 percent leverage ratio is far too low to keep banks in check. And if a bank ran up against the 3 percent leverage ratio, that would be a terrible sign! It would mean that the bank had far too much leverage, no matter what their assets looked like.”

It’s not clear what will be added as Dodd-Frank goes on, though right now there’s several obvious giveaways to community banks to get their support. A notable change is that financial institutions with under $10 billion in assets would be excluded from small business loan data collections of the Equal Credit Opportunity Act. This is something which community activists groups fought tooth and nail to get included in Dodd-Frank. That’s likely to bring much criticism from groups who would normally support this bill.

As Dodd-Frank is entering the endgame, it is appropriate for Congress to consider what needs to be expanded and trimmed in the final bill. More and more people are arguing that leverage ratios, which many had hoped would be a more important part of the regulatory rules, won’t meet the need for a properly capitalized banking system. The question is now how Congress should react.