A Good Way to Shrink the Big Banks (Bipartisan Edition)
To my surprise there is some bipartisanship left in Congress. Sherrod Brown (D-OH) and David Vitter (R-LA) wrote a letter to Ben Bernanke stating in part (ht Simon Johnson):
“We urge you to revisit your proposed rule and modify it so megabanks fund themselves with proportionately more loss-absorbing capital per dollar of assets than smaller regional or community banks. The surcharge on 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.”
The normal language version of what they are saying is “charge big banks a fee for being big so that they get smaller”. The level of capital a bank holds is proportional to their assets (mostly loans). Under the Basel 2 rules, a bank must have at least 8% capital levels as a total of risk-weighted assets. What that means is they must have equity (money the owners have put in that is decreased dollar for dollar with their losses) that are 8% of the value of loans they give (weighted by the riskiness of their loans). At its most simplest, if a bank lends out $100, they must have at least $8 in capital that absorbs any losses on their loans, keeping depositors from losing any money or relying on the FDIC to make up any shortfall.
Now, how do big banks differ from small banks? Small banks fail all the time (last Friday saw the 40th bank failure this year) in recessions, and they do so without hurting the system as a whole because the FDIC steps in and takes them over before too much money is lost and, importantly, the FDIC takes the losses so no money held by depositors up to the $250,000 per depositor limit. Since deposit insurance came into existence, not one dollar insured by the FDIC was lost.
Big banks are another monster. They could possibly fail, but the effect would be catastrophic (see: 2008). There is a tacit understanding (although nothing guaranteed by law) that the Federal government will prevent any big bank from failing, either by putting money in directly (see: TARP) or by finding another bank to buy it (see: Washington Mutual). This is an indirect subsidy to these banks because they know that they will not be allowed to fail. That leads them to take higher risks than they otherwise would because at worst they will be out of a job (the taxpayers will be forced to absorb the loss).
Currently, Dodd-Frank and private efforts by Federal regulators have been trying to create a way for these banks to fail without bringing down the system through creating ‘living wills’ (instruction manuals for taking apart failed big banks). Republicans have decried Dodd-Frank as ‘excessive regulation’ (what did you expect?), but have not come up with a better solution except to say, “let them fail”, which 2008 showed will not happen (they would bring down the whole financial system with them, see: Lehman Brothers).
The idea proposed by Brown and Vitter works within the Dodd-Frank rules by saying to big banks, you can be big but you must show us how you can be dismantled and you must make it much less likely for you to fail, by holding higher capital levels. Bankers (and their shareholders) hate this proposal because it lowers the amount of money they make.
For a simple example, take a bank with:
$10,000 in loans
$9,200 in deposits
$800 in capital
This bank meets the 8% capital requirement. If its loans go down in value $800 (8%), then its capital goes to zero and it is insolvent (out of business). But, assume that everything is going well for now. The bank charges 10% interest on the loans and pays depositors 2%. Its profit is $1,000 from interest and it pays $184 in interest to its depositors and earns $816, which it uses to pay expenses (assume those take up $500, for tellers and buildings and ATMs) and pays the rest to its shareholders, giving them $316, or 39.5% return on their equity capital.
Now, if this bank were designated as a “big bank” and had to hold extra capital, say 10%, to lower the chance that it failed (it would need to lose $1,000 on its loans, not $800), and it had the same income and expenses (with $9,000 in deposits and $1,000 in capital), then it would earn $1,000 in interest, and pay $180 in interest to depositors, and pay $500 for tellers etc, there would be $820 leftover for shareholders, but there would be more equity ($1,000 versus $800) to spread those earnings over, and instead of $316 in profit (representing 39.5% return on capital), the bank would earn $320, giving a 32% return on capital.
The numbers above are not realistic, but the effect of higher capital is. Higher capital for banks does make them less likely to fail, but it also decreases the bank’s profitability, which makes them less desirable for shareholders (and as a result if that bank were publicly traded, its stock would probably fall if it had to hold more capital). If the bank could go back to being profitable if, for example, it could split into 2, then shareholders would likely demand that it do so.
This would have an important impact. It would make banks smaller on average (lowering the chance of needing a bailout from the taxpayers) and make the banking sector more safe because the FDIC knows how to handle smaller bank failures. It takes them over and either sells them or winds them down.
Critics of these proposals (usually the people who make money from the implicit subsidy the government gives to large banks) say that our banks will not be able to compete internationally if they are not huge. Or they claim that depositors will be hurt by lower quality service and higher fees. I don’t think they are right in either case, but I don’t have the time to dig up the empirical evidence to disprove them right now. On the second point though, I will offer my anecdotal evidence. I left one of the massive banks (Wells Fargo) for a credit union because of the high fees, and the credit union I have been a member of for over 2 years now has offered fantastic services, none of the crappy fees I was used to with Wells Fargo and even pays interest on my checking account. Whodathunkit?