Why We Don't Need Brown-Vitter — Yet

Patience is among the many virtues lacking in politics.

The consensus in Washington is that "more needs to be done" to end "too big to fail," but the bulk of the reforms Congress and the Basel Committee adopted in the wake of the 2008 crisis have yet to be adopted. So no one truly knows if we've done "enough" yet.

Will proposed counterparty limits reduce interconnectivity among the giant firms and in turn cure contagion risks? Will higher, stronger capital requirements lead the largest banks to shrink? Will living wills work? Will regulators have the backbone to take over and unwind a big firm that gets into trouble?

I could go on, but every major question about the safety and soundness of the financial system is addressed in either the Dodd-Frank Act of 2010 or the Basel III rules agreed to by international regulators on the Basel Committee that year.

We just don't know yet whether the answers will be effective, and that's where impatience comes in.

Sens. Sherrod Brown, D-Ohio, and David Vitter, R-La., jumped into the "do more" breach last week with their bill to crank up the equity capital ratio on the largest banks to 15% of assets.

The lawmakers want to make the system safer and figure the more capital, the better.

But is it? I don't know, and neither do Brown and Vitter.

Neither has explained how their Terminating Bailouts for Taxpayer Fairness Act will affect the largest banks, the industry or the economy. Is 15% the right level? Is $500 billion the right size? Will lending crater? Will economic growth suffer?

Let's assume the legislation is enacted as written and the largest banks all decide to break themselves up to get below the $500 billion asset threshold to qualify for a lower capital requirement of 8%. That would make the largest bank in the U.S. the 51st largest in the world, just ahead of Banque Federative du Credit Mutuel in France.

It would also mean those six giant firms turned into 21 companies.

How would these smaller U.S. banks compete with foreign rivals that get to hold half as much capital? Would foreign government retaliate if the U.S. pulls out of Basel III? Would the U.S. still be the center of global finance?

We need to consider these questions and the repercussions of the answers.

Brown and Vitter have presented no analysis of the costs and benefits of their bill and haven't yet made a convincing case that adopting this legislation will improve our financial system.

That may be why so few lawmakers or regulators are embracing it. About the only enthusiastic support has come from the Independent Community Bankers of America. "It's time to put capital back into capitalism," ICBA president Cam Fine says.

And capital is at the heart of Brown-Vitter. Financial firms with assets of more than $500 billion would have to hold 15% of assets as tangible equity capital. Banks with $50 billion to $500 billion would have to meet an 8% ratio.

The bill's impact would be magnified by the fact that it would expand what's considered an asset by including some off-balance-sheet assets and uncollateralized derivatives.

Brown-Vitter takes another step beyond the 15% and the broader definition of asset, requiring a "surcharge" to offset "any distortion of capital levels" resulting from federal government programs like deposit insurance.

Duke law professor Lawrence Baxter considers himself "generally sympathetic" to the Brown-Vitter legislation, but says in an email that he's "far from convinced" it's the right approach.

Baxter agrees that it seems the senators haven't thought through the ramifications "of this enormous diversion of investment from other sectors, or of the substitution of (expensive) capital for (cheap) debt.

"Appealing as a requirement for much higher levels of capital might seem," Baxter writes, "the changes in economic dynamics that a capital-based restructuring of the banking industry might entail — ranging from redeployment of capital from other industries to credit migration into the shadow banking sector — are not yet understood. These changes might well prove counterproductive, so it is at the very least premature to leap to such a solution."

It's hard to figure out just how much more capital the largest banks would need. Goldman Sachs has estimated the biggest banks would need to raise $908 billion in new equity while the next-tier banks would need an extra $145 billion. That squares nicely with the $1.2 trillion estimate S&P gave for all banks.

Critics dismiss these reports as little more than biased industry spin.

But Keefe, Bruyette & Woods took a crack at estimating the megabanks' capital ratios under Brown-Vitter and the results are, to quote one of the report's authors, "pretty eye-opening." Morgan Stanley's capital would have to nearly quadruple its current capital levels to meet the new standard. Even Wells Fargo, which came out the winner in the KBW report, would face a hefty capital raise. On average, "You'd have to triple the capital levels of the biggest six banks," Fred Cannon, KBW's director of U.S. research, says in an interview. "They'd have to go out to the market and raise a lot of capital or they would have to break up."

Asked how much capital these banks would have to raise, Cannon chose a descriptive word over a number: "a boatload."

Before you write Cannon off as a defender of big banks, read on.

"There is no … evidence to show that this would necessarily curtail lending and send the economy into a tailspin," Cannon says.

In contrast, Goldman says Brown-Vitter would "remove an estimated $3.8 trillion in lending capacity from the U.S. banking system, or 25% of today's levels."

Cannon says higher capital can lead to less lending, but it doesn't have to. It all depends on the choices individual banks make. Some banks may choose to shrink assets, including loans, to reach the stricter capital ratios, but others won't. "It can be argued both sides, and I don't think the evidence is all that clear on either side," Cannon says.

What's more, Cannon agrees with the main goal of senators' legislation: cutting the giants down to size. "A transition to smaller, safer institutions would be probably the best outcome for the U.S. economy over time," he says.

But, Cannon adds, "It would be best to let the market figure those things out rather than have it be dictated from Washington."

That brings me back to patience.

The senators ought to turn up the pressure on regulators to get crucial Dodd-Frank reforms in place. Then policymakers can see where we actually do need "more."

If policymakers decide more action is needed, then let's raise capital levels at a manageable pace, such as half a percent at a time. Fed Gov. Jeremy Stein called for such a "turning-up-the-dials approach" last month.

That approach makes more sense and it would be easier to find the balance between enough capital — and too much.