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The US must hold firm on bank capital rules

The Honorable Sheila C. Bair

Irish dramatist George Bernard Shaw once opined that to know nothing and think you know everything points to a political career. Members of the US Congress wandering into the complicated subject of bank capital must have taken his advice. Few things are more complex than rules designed to constrain excessive borrowing by large “systemic” financial institutions. There are “leverage ratios” — relatively simple metrics that require a bank to hold a minimum amount of equity relative to total assets — and “risk-weighted ratios” that specify equity minimums based on the perceived riskiness of a bank’s holdings.

US politicians, with some help from regulators, are trying to weaken these rules, setting a dangerous global precedent. Both Republicans and Democrats supported legislation giving the three largest US custody banks an average of a 20 per cent reduction to their leverage ratios.

The Federal Reserve followed up with a broader proposal that would give a 20 per cent reduction to the eight biggest banks insured by the Federal Deposit Insurance Corporation. Industry lobbyists then convinced a select group of Republican House and Senate members to ask the Fed to also reduce the risk-based capital surcharge that applies to the largest US banks. Because the Fed’s proposed changes to the leverage ratio are linked to this surcharge, reducing it will further reduce the leverage ratio as well.

After the financial crisis, there was broad bipartisan consensus in favour of strong capital rules. They were a centrepiece of the Democrat-backed Dodd-Frank financial reform law. But Republican alternatives also favoured tough capital requirements because they use market discipline to tame excessive risk-taking. Forcing equity owners of a bank to put up more capital protects taxpayers, and gives shareholders incentives to monitor against reckless bets.

But now some in the Republican party have decided to side with self-interested bankers. They argue our stronger capital rules put US banks at a competitive disadvantage, even though they have come to dominate global finance. This echoes ill-fated arguments I heard while running the FDIC in 2006, when some in Congress tried to pressure us to adopt international capital rules embraced by Europe. Those would have reduced median capital among large US banks by 30 per cent.

Tough capital rules are a competitive advantage, not weakness. Studies show that well-capitalised banks do a better job of lending than more leveraged rivals. Thick capital buffers keep the banking system functioning through economic cycles. Every dollar reduction in bank capital weakens the public’s protection against big failures.

Lobbyists argue that regulators now have better tools to handle the failure of a large bank than they did before the crisis, which is true. But our first priority should be to prevent large bank failures. Weakening the capital base of US banks makes us vulnerable to insolvencies and widespread credit disruption during the next downturn, and dramatically increases the likelihood of another taxpayer bailout.

The Fed should be free from political influence in the exercise of both monetary and regulatory policy. The Federal Reserve Board has autonomous funding and lengthy terms so that its members can withstand the destructive animal spirits of politicians up for re-election. Congress has a role in Fed oversight. But that does not mean the Fed should succumb to partisan pressure from members seduced by bank lobbyists.

The Systemic Risk Council, a group of former central bank and regulatory heads that I founded, has forcefully argued against any weakening of bank capital rules, as have broad-based public interest groups such as Americans for Financial Reform. Prominent economists such as former Fed vice-chairman Donald Kohn, supported by several Fed regional bank heads, have argued that the Fed should consider raising, rather than reducing, capital requirements because we are near the end of the economic cycle. That is when lending standards tend to loosen and asset values peak.

The Fed should listen to these fair-minded voices. If the US cedes its leadership on strong bank capital, the slide will not stop there. Lobbyists will take their case to UK and European regulators who have mostly resisted their demands, partly because of strong US rules. The slippery slope of deregulation could lead to a financial system that is even less resilient than the one we had 10 years ago.

As the midterm elections approach, US voters should ask where their candidates stand on bank capital: with lobbyists or with taxpayers.

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