Better than Brown-Vitter: Make Banks Issue Long-Term Debt

Sens. Sherrod Brown, D-Ohio, and David Vitter, R-La., in introducing legislation to end "too big to fail" banks and taxpayer bailouts, accomplished a few positive things even though their bill in its current form has virtually no chance of enactment. 

On the positive side, the senators broke ranks with Washington's official and patently false claim that the Dodd-Frank Act ended "too big to fail" and taxpayer bailouts.  Second, a liberal Democrat teaming with a conservative Republican is a welcome display of bipartisanship seldom seen in Washington these days. 

The core of Brown-Vitter is a requirement that banks larger than $500 billion maintain 15% equity capital to total assets – multiples higher than has been required of these banks in modern times and nearly double smaller bank requirements. I'm a "hawk" on bank capital and regulation, so I'm with Brown-Vitter in my heart, but my experience tells me that what they are proposing will do far more harm than good.

The U.S. regulatory system is fragmented and politicized and Dodd-Frank made it worse.  But even if we had an ideal regulatory system, we cannot rely on regulation alone to control excesses in the financial industry that all too often lead to crises and panics. 

To end the seemingly endless boom/bust cycles and accompanying banking crises and panics, we need smarter and less politicized regulation.  And it must be accompanied by greater marketplace discipline, particularly on the largest firms heretofore regarded as too big to fail.

Requiring the largest firms to increase their equity capital to 15% as proposed by Brown-Vitter is not the answer.  This requirement would lower returns on equity to the point that the banks will not be willing/able to raise sufficient capital and will instead shrink their balance sheets. 

Do we really want the six largest U.S. banks (JPMorgan Chase, Bank of America, Citigroup, Goldman Sachs, Wells Fargo and Morgan Stanley), holding over 50% of the nation's financial assets, to decrease their lending dramatically and/or increase significantly the price of loans?  Or to become highly selective and refuse to lend to those who most need to borrow?  Does anyone believe this will create economic growth and jobs?  Do we believe much smaller banks can handle the worldwide banking needs of large U.S. companies or that our national interests will be served by having those needs met by foreign banks? 

Because equity capital is permanent and cannot declare an event of default when it perceives the risks to be excessive, it's only marginally effective in imposing discipline on management.  Moreover, equity holders have upside potential from taking risks and are therefore more tolerant of risk than creditors.

A much more effective and less detrimental form of market discipline is to require that banks issue regularly long-term senior and subordinated debt.  Total long-term debt and equity capital should be set high enough to cover any losses an institution might be reasonably expected to incur. 

If a large bank becomes insolvent, the Federal Deposit Insurance Corp. would place it in a "bridge bank" operated under FDIC control with new management and directors.  The bridge bank would continue serving the needs of depositors and borrowers, leaving the equity and long-term debt behind in a receivership with no guarantee of recovery.  The bank would be reprivatized as soon as possible.

I would set total tangible equity capital at 8% of total assets and would also require that long-term debt be no less than 12% of assets for a total cushion of 20%. It's difficult to imagine the FDIC, much less taxpayers, incurring losses on a failed bank with this much protection.  If more cushion was desired, a 5% or 10% hold-back on uninsured depositors could also be imposed.

This plan would not only protect the FDIC and taxpayers, it will impose discipline that will make failures much less likely.  A risky bank would have to pay higher interest to issue long-term debt, sending a clear negative signal to management, the board, investors and regulators. The bank ultimately might not be able to issue debt, forcing curtailment of growth and risk-taking.

Some suggest that setting a capital requirement as a percentage of total assets (rather than risk-weighted assets) may encourage banks to invest in riskier assets to increase returns.  This concern is misplaced for several reasons.

First, risk-based capital measures have proven spectacularly unsuccessful and in fact played a major role in bringing about the 2008-2009 crisis by assigning unreasonably low-risk ratings to politically favored classes of loans such as residential real estate lending and sovereign debt. 

Second, if regulators want to retain risk-based capital measures as a backstop to prevent excessive risk-taking, they are certainly free to do so.

Third, the long-term debt market will be at least as effective in measuring and pricing bank risk as models developed by regulators.

Fourth, it's past-time for regulators to return to comprehensive on-site examinations of large banks to assess risks and capital and liquidity needs instead of relying so heavily on backward-looking, procyclical models.

The plan I'm suggesting would put large and small banks on a level playing field.  Requiring small banks to hold more capital than large banks, as we have done for decades, provides an unfair pricing advantage to the larger banks.  The reverse would be equally unfair.  Government-imposed capital requirements should not discriminate based on size of institution – period!

The suggested plan is simple, fair, easy to understand and predictable and would help end financial panics.  The plan doesn't require legislation, although regulators may need a serious threat of legislation before they act.  Maybe in the end this will be Brown-Vitter's most significant contribution.

William M. Isaac, former chairman of the Federal Deposit Insurance Corp., is global head of financial institutions for FTI Consulting, chairman of Fifth Third Bancorp and author of "Senseless Panic: How Washington Failed America." The views expressed are his own.