WASHINGTON, D.C.—U.S. Senators Sherrod Brown (D-OH) and David Vitter (R-LA), both members of the Senate Banking Committee, are pressing Federal Reserve System (Fed) Board of Governors Chairman Ben Bernanke over the Fed’s recently-proposed capital standards rule. In a letter sent to Bernanke today, the senators urge Chairman Bernanke and the Fed’s Board of Governors to revisit the proposed rule and modify it to better align capital requirements to the risks posed to the banking system. Modifying the proposed rule and requiring the biggest banks to have stronger capital reserves would help preserve the safety and soundness of the American financial system, the senators assert, and will help ensure that megabanks are no longer “too big to fail” or will require another taxpayer bailout.
“The Federal Reserve must not miss an opportunity to craft capital standards that will help prevent taxpayers from being forced to fund another Wall Street bailout,” Brown said. “Wall Street banks—not Main Street taxpayers—should be on the hook for their own mistakes. Stronger capital rules will help ensure that megabanks are able cover their losses and are no longer ‘too big to fail.’”
“Placing higher capital requirements on megabanks is a common sense way to fix the dangers of too-big-to-fail, and Chairman Bernanke has even said this would make our financial system safer with limited impact on the economy,” said Vitter. “The megabanks should bear their own risks so that taxpayers won’t get hung out to dry with another Wall Street bailout.”
The Dodd-Frank Act provides the Federal Reserve Board with authority to set enhanced risk-based capital requirements and leverage limits for the largest banks and financial institutions. The Fed’s proposed rule implementing enhanced prudential standards states that the capital surcharges for Systemically Important Financial Institutions (SIFIs) would be ‘based on the Basel Committee on Banking Supervision framework,’ also known as Basel III. The Board of Governors’ proposed rule requests input regarding the appropriate scope of application for a SIFI capital surcharge, and Brown and Vitter note that “all SIFIs are not created equal, and, when crafting capital surcharges in accordance with Basel III and Section 165, the Board should keep in mind the distinctions between money-center banks and regional banks. Systemic risk capital buffers should be imposed based upon the actual risks posed to the system, not merely in response to designation as a SIFI.”
“Placing higher capital requirements on megabanks is a common sense way to fix the dangers of too-big-to-fail. The megabanks should bear their own risks and have their financial incentives properly aligned in a way that protects U.S. taxpayers,” the senators wrote. “Robust capital buffers will more appropriately align financial incentives and prevent future financial sector bailouts. However, in order to do so properly, you must have the board revisit the proposed rule to implement Basel III and modify the rule to include a SIFI surcharge significant enough to change the incentives for the largest banks.”
The full text of the letter is below, and the PDF can be seen here.
The Honorable Ben S. Bernanke
Board of Governors of the Federal Reserve System
20th Street and Constitution Avenue, N.W.
Washington, D.C. 20551
Dear Chairman Bernanke:
We write today to impress upon the Board the importance of robust and reasoned capital standards that will preserve the safety and soundness of our financial system for years to come. Your proposed rule on capital standards misses a huge opportunity to address the too-big-to-fail issue by setting the so-called SIFI surcharge far too low. We urge you to revisit your proposed rule and modify it so that megabanks fund themselves with proportionately more loss-absorbing capital per dollar of assets than smaller regional or community banks. The surcharge on the megabanks should be high enough that it will either incent them to become smaller or will help to ensure they can weather the next crisis without another taxpayer bailout.
Placing higher capital requirements on megabanks is a common sense way to fix the dangers of too-big-to-fail. As you have said in the past, research done by the Federal Reserve and other regulators shows the tougher capital requirements will “significantly reduce the threat of a massive financial crisis” while doing little to limit economic growth. The megabanks should bear their own risks and have their financial incentives positively aligned in a way that protects U.S. taxpayers.
Greater capital is essential to withstand inevitable losses in the banking industry. In the 1920s and 1930s, the big New York banks funded 15 to 20 percent of their assets with capital. This enabled them to survive the Great Depression.
Section 165 of the Dodd-Frank Act provides the Board with authority to set enhanced risk-based capital requirements and leverage limits for systemically important financial institutions. Section 165 authorizes the Board to “differentiate among companies on an individual basis or by category, taking into consideration their capital structure, riskiness, complexity, financial activities (including the financial activities of their subsidiaries), size, and any other risk-related factors that the Board of Governors deems appropriate.” As the committee report accompanying the Senate-passed Restoring American Financial Stability Act makes clear, “[t]he standards and requirements shall . . . increase in stringency as appropriate in relation to certain characteristics of the company, including its size and complexity.”
Your proposed rule implementing the Section 165 enhanced prudential standards states that the capital surcharges for Systemically Important Financial Institutions (SIFIs) would be “based on the B[asel] C[ommittee] on B[anking] S[upervision] framework[.]” The Basel Committee on Banking Supervision has already proposed requirements of 7 percent Tier One Common Equity and 8.5 percent Tier One Capital, with an additional proposed surcharge between 1.0 percent and 2.5 percent for globally systemically important banks (G-SIBs). The G-SIB surcharge is based upon the following indicator categories: 1) cross-jurisdictional activity; 2) size; 3) interconnectedness; 4) substitutability; and 5) complexity.
Your proposed rule requests input regarding the appropriate scope of application for a SIFI capital surcharge. Bank of Canada Governor Mark Carney has said that “the Basel rules have always been, and continue to be, international minimums, rather than a ‘one-size-fits-all’ approach.” We agree with this view, and support the recent statement of Governor Daniel Tarullo that enhanced capital rules will be “graduated based on the systemic footprint of the institution.” All SIFIs are not created equal, and, when crafting capital surcharges in accordance with Basel III and Section 165, the Board should keep in mind the distinctions between money-center banks and regional banks. Systemic risk capital buffers should be imposed based upon the actual risks posed to the system, not merely in response to designation as a SIFI.
Regulators must oversee SIFIs – including their capital requirements – commensurate with their size and risk, as required by the Basel rules and the Dodd-Frank statute and its accompanying legislative history. Indeed, the Basel Committee has identified 29 institutions as G-SIBs. Of the eight U.S. institutions on this list, none are regional banks. Examining the indicators proposed by the Basel Committee reveals the distinctions between money-center banks and regional institutions. These metrics clearly demonstrate that U.S. regulators must focus their efforts to impose enhanced capital requirements on the largest, most complex financial institutions, and not the smaller, regional institutions that engage in traditional banking services and whose systemic footprint is limited or inconsequential.
Cross-jurisdictional activity includes cross-jurisdictional claims and cross-jurisdictional liabilities.
Currently, the nation’s largest and second-largest banks have subsidiaries based in 37 and 50 countries, respectively. Some estimate that the five largest American banks have between $45 and $80 billion in exposure to the PIIGS countries. Estimates of total guarantees, including government, bank, and corporate debt range as high as $518 billion. Others also note that the biggest banks have considerable direct exposure to periphery countries, as well as indirect exposure to countries like France and Germany that also have considerable exposures to the periphery.
These institutions present unique challenges that regional banks do not. The international nature of such large, complex, global institutions makes front-end regulation more difficult. In the event of failure, their cross-jurisdictional nature also makes orderly resolution more complicated.
An institution’s size is significant because the IMF reports that the size of an institution, relative to its home country GDP or relative to the financial system, seems to play a key role in decisions about whether the bank receives a bailout in the event of distress.
In 2006, before the financial crisis, the top 10 banks held 68 percent of total bank assets. By the end of 2010, they held 77 percent of total banking assets. During the financial crisis, the six largest banks, in particular, experienced the most dramatic growth, with the nine largest banks and securities firms consolidating into what are now the six largest bank holding companies. As a result of these mergers, three of the four largest megabanks grew by an average of more than $500 billion.
The assets of the six biggest U.S. banks currently equal 62 percent of U.S. Gross Domestic Product, up from 18 percent in 1995. Together, these six banks are now twice as large as the rest of the top 50 U.S. banks combined. The assets of the largest regional bank amount to 2.2 percent of U.S. GDP; 2.8 percent of U.S. commercial banking assets; and 2.6 percent of U.S. commercial banking deposits. A $50 billion BHC’s assets amount to approximately 0.3 percent of U.S. GDP; 0.4 percent of U.S. commercial banking assets; and 0.6 percent of U.S. commercial banking deposits.
Interconnectedness is measured by intra-financial system assets, intra-financial system liabilities, and the ratio of wholesale funding.
It has been estimated that in mid-2008, the five largest broker dealers collectively financed 42 percent of their assets through repo borrowing. The largest banks have been transformed “since the early-1980s from low return on-equity (RoE) utilities that originate loans and hold and fund them until maturity with deposits, to high RoE entities that originate loans in order to warehouse and later securitize and distribute them, or retain securitized loans through off-balance sheet asset management vehicles.” As a result of this transformation, “the nature of banking has changed from a credit-risk intensive, deposit-funded, spread-based process, to a less credit-risk intensive, but more market-risk intensive, wholesale funded, fee-based process.”
The measures of substitutability include assets under custody, payments cleared and settled through payment systems, and values of underwritten transactions in debt and equity markets.
The largest U.S. banks have substantial footprints in both commercial banking and capital markets activities. George Washington University Law Professor Arthur Wilmarth estimates that these firms were responsible for, “about $9 trillion of risky private-sector debt … in the form of nonprime home mortgages, credit card loans, CRE loans, LBO loans and junk bonds … [and] $25 trillion of structured-finance securities and derivatives whose value depended on the performance of that risky debt, including MBS, ABS, cash flow CDOs, synthetic CDOs and CDS[.]”
There is still a high degree of concentration among the largest institutions across various financial products:
- As of September 30, 2010, the six biggest banks accounted for 35 percent of all U.S. deposits and 53 percent of all banking assets;
- The six largest banks also service roughly 56 percent of all mortgages, and nearly two-thirds of the mortgages in foreclosure;
- In 2011, the top 10 banks underwrote 70 percent of the municipal bond offerings, with the top three – JPMorgan, Citi, and Bank of America Merrill Lynch – underwriting 38.3 percent of all business.
Finally, the largest U.S. bank is also the second-largest player in the settlement of contracts in the $1.8 trillion-a-day tri-party repo market.
The measures of complexity include over-the-counter derivatives notional value, Level 3 assets, and trading book and available for sale securities values.
Professor Wilmarth told the Subcommittee on Financial Institutions and Consumer Protection that “eighteen major L[arge] C[omplex] F[inancial] I[nstitution]s … were the dominant players in global securities and derivatives markets during the credit boom.” In 2010, the trading revenues of the six largest U.S. institutions represented 93.1 percent of such revenues at all American banks. The top five commercial banks are responsible for 96 percent of the notional value of derivatives contracts at U.S. banks and 86 percent of the industry’s credit exposure. Five of the six largest bank holding companies – Bank of America, Citigroup, Goldman Sachs, J.P. Morgan, and Morgan Stanley – are part of the so-called “G14 institutions” that do most of the trading in OTC derivatives world-wide. The largest banks also hold the vast majority of their derivatives exposure in their insured depository institution affiliate.
In 2007, Bank of America, Citigroup and JPMorgan Chase guaranteed asset-backed commercial paper in an amount that exceeded the total value of their combined Tier 1 capital by 50 percent. According to some estimates, The U.S. banking system currently holds approximately $7 trillion in deposits, but the credit market includes $2.7 trillion in bank and leveraged loans, $3.3 trillion in commercial mortgages, $1.3 trillion in subprime mortgages, $5.8 trillion in non-agency prime residential mortgages, and $2.6 trillion in consumer loans.
Concentrating complex, structured securities upon leverage loans and risky mortgages within the largest, most complex megabanks created what Professor Wilmarth calls a “pyramid of risk” caused by “multiple layers of financial bets.”
Global Megabanks Are Distinguishable from Regional Banks
In contrast to global banks, regional banks primarily serve business and consumer customers in their local markets. In 2011, regional banks made 1.9 million small business loans totaling $73 billion and provided $254 billion in commercial and industrial loans to medium-sized firms. These banks focus on traditional lending, with loans accounting for two-thirds of their assets (compared to about one-third for money-center bank holding companies (BHCs)). Commercial and industrial loans are 21 percent of regional bank lending compared to 11 percent at a typical money-center BHC. In the last two years, lending at the four largest U.S. banks fell 4.9 percent – with their share of national loans shrinking by 2 percent – while regional banks increased their lending by 9.8 percent.
Regional banks’ risk-adjusted return on capital is also generally higher than those of large, complex banks – meaning that they have relatively safe assets and make steady returns. Large, complex banks engage in activities like securities trading and underwriting, investment banking, and derivatives origination and trading, which are volatile and unpredictable. Regional banks, by contrast, have limited financial market activity, with less than one percent of notional derivatives contracts and about one percent of trading assets. Moody’s recently downgraded the ratings of the six largest U.S. banks due to the “volatility and risks that creditors of firms with global capital markets operations face.” In doing so, Moody’s noted that “these risks have led many institutions to fail or to require outside support.” They did not downgrade any regional banks.
Though some regional banks exceed the $50 billion threshold for “systemically important” banks, some have suggested that this designation is intended to be over-inclusive, in order to lessen the perception that the SIFI designation is synonymous with “too big to fail” status. The former director of the Federal Reserve’s Division of Banking Supervision and Regulation has reportedly said that, “nobody really regards $50 billion as systemically risky.” Markets have generally absorbed the failures of regional banks. In 2008, the failure of the $307 billion thrift Washington Mutual came at “zero cost” to taxpayers, according to the FDIC.
As we have discussed at length, robust capital buffers will more appropriately align financial incentives and prevent future financial sector bailouts. However, in order to do so properly, you must have the Board revisit the proposed rule to implement Basel III and modify the rule to include a SIFI surcharge significant enough to change the incentives for the largest banks.
We agree with the Board’s belief that enhanced capital requirements for the largest, most complex institutions will “meaningfully reduce the probability of failure of the largest, most complex financial companies and would minimize losses to the U.S. financial system and the economy if such a company should fail.” And, we further agree that G-SIFI capital surcharges “would help require that these companies account for the costs they impose on the broader financial system and would reduce the implicit subsidy they enjoy due to market perceptions of their systemic importance.” However, the proposed rule is ultimately just a baby step in the correct direction. The Board must do more in order to protect taxpayers and the financial system.
Properly constructed capital standards will take into account the extent to which institutions are already subject to capital requirements imposed by their respective regulators. Regulation of these institutions should not dramatically scale up or fall off a cliff once particular benchmarks have been reached. As Governor Tarullo has argued, $51 billion bank holding company should not be treated significantly differently from a $49 billion bank holding company, and we are encouraged to hear him say that that, “the supplemental capital requirement for a $50 billion firm is likely to be very modest.”
Oversight should not remain constant once particular thresholds have been crossed, so that a large regional bank that makes loans to consumers and small businesses is not treated the same way as a trillion-dollar money-center bank. Rules for capital and leverage should move on a sliding scale, with a focus on the largest and most complex megabanks.
Thank you for considering our views on this important matter.