Brown/Vitter: Two Steps Forward, One Step Back

Sen. Sherrod Brown takes his seat beside Sen. Jon Tester

Photo by T.J. Kirkpatrick/Getty Images

Sherrod Brown and David Vitter had been rumored to be working on some kind of legislative effort to break up “too big to fail” banks, but according to draft text obtained by Tim Fernholz what they’ve actually come up with is a bit different. In many respects, it’s a great bill that woiuld take us forward on bank safety. But it also contains a significant step back.

The good news is it features leverage rules that are considerably tougher than Basel III. Banks would face a hard floor of 10 percent common equity rather than the Basel III ratio of 4.5-8 percent and Brown/Vitter wouldn’t let you do risk-weighting of the assets. Basically the Brown/Vitter leverage rules would make American banks much less likely to fail than is currently the case, probably at the cost of making it somewhat harder for consumers to get mortgages and consumer debt products. Brown/Vitter also tackles bank size by saying that there’d be an additional 5 percent capital surcharge on banks with over $400 billion in assets (i.e., JP Morgan Chase, Bank of America, Citigroup, Wells Fargo, Goldman Sachs, and Morgan Stanley). That wouldn’t formally require the six largest banks to break up, but it would give the larger regional banks a substantial competitive advantage vis-a-vis the megabanks while insuring that the largest banks would be super-safe.

At the same time, instead of simply superseding the Basel III rules on leverage Brown/Vitter would supersede Basel III in its entirety including regulations about liquidity and other matters.

This highlights one reason a lot of people in the Treasury Department are loath to see people talking about new bank legislation. They see it as essentially opening up a can of worms that gives financial institutions dozens of new venues with which to attack ongoing efforts to toughen-up regulations. And on Twitter, Daniel Davies was suggesting that you could basically use off balance sheet vehicles to punch an enormous loophole in the alleged equity requirements here. Basically, instead of making a highly leveraged investment, you make a somewhat leveraged investment in an entity that is itself leveraged. In other words, while the risk-weighting process can be used as a regulatory arbitrage the absence of risk-weighting can also work that way. Given the exceptional complexity of existing financial regulations it’s very tempting to say “what we really need to do is brush all that aside and just do X” but the rules got complicated in part because it’s really hard to turn “just do X” into an operational regulatory strategy.