Brown-Vitter Bill Creates More Problems Than It Solves

In the last twelve months, one could easily get whiplash trying to keep up with the examples of bad risk management and extreme arrogance by many managers at the large, interconnected banks. These egregious scandals have frustrated Americans learning to live in the post-crisis world of anemic U.S. economic growth and a mostly recessionary Eurozone. The fact that no high level executive from the banks has even been indicted, much less gone to jail, for Wall Street’s role in worsening the standard of living of millions of Americans, has also understandably angered people and fueled the fire behind “too big to fail”.

In this environment, it is easy to see how some may be very pleased with Sens. Sherrod Brown, D-Ohio, and David Vitter, R-La., who recently unveiled their Terminating Bailouts for Taxpayer Fairness Act, a bill that focuses principally on requirements for big banks.

If no other bank reform frameworks or laws already existed, the Brown-Vitter bill might look like a good start. Given that two-thirds of Dodd-Frank rules, such as the Volcker rule, have yet to be finalized and that the Basel III minimum international capital standards are far from even being fully proposed in the U.S., the Brown-Vitter bill adds more regulatory uncertainty and confusion to a financial sector that desperately needs clarity and direction.

Dodd-Frank’s Title I, “Financial Stability — Systemic Risk Regulation and Oversight”, empowers bank regulators to require banks and nonbanks over $50 billion in assets to have the necessary capital and liquidity so that they do not collapse and cause systemic risk. Specifically, Section 165 of the Dodd-Frank Act requires the Federal Reserve to issue enhanced prudential standards for: U.S. bank holding companies with $50 billion or more in total consolidated assets; foreign banking organizations with $50 billion or more in global total consolidated assets; and U.S. and foreign nonbank financial components that have been designated as systemically important by the Financial Stability Oversight Council

The enhanced prudential standards include: heightened capital standards, liquidity standards, single counterparty credit limits, risk management requirements, stress testing requirements and early remediation framework.

It is regulators who have chosen to take guidance from the Basel frameworks, originated in the early 1970s as more countries realized how interconnected their banking systems were becoming. Basel is international guidance. This means our regulators can choose to impose whatever requirements are necessary given the nature of our banking system and current economic conditions.

The main reason Brown and Vitter introduced their bill is that they feel Dodd-Frank has enshrined the practice of bailing out banks. Both Title I and Title II are predicated on the belief that taxpayers should be protected and should not ever bail out banks again. Title I requires big banks to write living wills where banks must explain the identification process for its domestic and international funding, liquidity needs, interconnections and interdependencies and management information systems. Dodd-Frank very specifically through Title II, “the Orderly Liquidation Authority”, prohibits the bailing out of banks by taxpayers.

Principally, the Brown-Vitter bill calls for large banks to use higher quality capital. This is an excellent idea since, unfortunately, it took the financial crisis for many to finally see that tax-deferred assets and hybrid capital have no loss absorbency value in a time of stress. Yet, higher quality capital requirements are already a key part of Basel III’s Pillar I and a great improvement in comparison to what was acceptable under Basel II. U.S. banks, fortunately, are in a much better position to raise equity or deleverage in order to have loss absorbent capital.

Secondly, Brown and Vitter want large banks to hold 15% capital again non-risk-based assets. Basel III requires much higher capital than Basel II, but also each local regulator can call for more capital if necessary. Calling for higher capital for systematically important financial institutions is already part of Basel III; it’s called the SIFI buffer. Remember Basel is about minimum, not maximum standards.

The major reasons Brown and Vitter are against Basel III is because they say that it is complex and that banks allocate capital based on the system of risk-weighted assets. Like most of the media, they focus on the fact that banks can ‘manipulate’ risk-weighted assets. Those banks that are approved by regulators to use their own inputs for credit or market-risk models must meet numerous strict requirements beforehand. They also still have to calculate capital according to Basel guidelines for regulatory approved formulae.

There is no doubt that great variance exists in RWAs. In my experience, working on Basel projects globally for over a decade, I can say that indeed, some variance is caused by bank manipulation. Yet, other variance is because banks get to pick their models and have legitimate assumptions for risk drivers. Other variance occurs because supervisors have subjectivity in opining what models are well designed. Sometimes supervisors are not trained to understand models and are hesitant or not knowledgeable to ask relevant questions. If Basel III’s Pillar III, which provides guidelines for transparency, were to be implemented and supervised uniformly, the market would have a much better understanding about how banks calculate their risk capital. If market participants are that suspect of RWAs, why are we not seeing shareholders, equity or credit analysts ask more questions about RWAs at meetings?

Brown and Vitter argue that Basel’s leverage requirement is too low. That’s correct. It is only 3% of non-risk weighted assets. U.S. bank regulators have the power to propose and impose a higher leverage ratio. There is no need to go through a prolonged bureaucratic process in legislative chambers. Moreover, it is not the job of legislators to decide how much capital banks should have; that is the job of bank regulators. Legislators should provide them with the resources to do their job rather than all too often siding with the lobbyists camping out at regulators’ doors.

Thirdly, Brown-Vitter ostensibly calls for the U.S. to abandon its involvement in the Basel framework. Never mind that the U.S. pulling away from Basel III would signal to the rest of the world that we are not interested in global capital standards, which no doubt would only exacerbate bank regulatory arbitrage even more. As I wrote two weeks ago, Basel III is not just about capital allocation for credit, market and operational risks and capital conservation, procyclicality, liquidity and leverage buffers. Its three pillars are designed to improve banks’ risk management and transparency. Basel is not about managing by number and neither should any regulatory framework.

Brown and Vitter have argued that they are frustrated with the implementation pace of Dodd-Frank. It is unclear how they can think that if their bill were to pass, regulators would be able to write rules any faster given their continued resource constraints and continued pressure from numerous lobbies. The Brown-Vitter bill injects more financial regulatory uncertainty at a time when banks have been spending millions of dollar upgrading systems to comply with Dodd-Frank and Basel III. Even if Brown-Vitter’s capital requirements were implemented, U.S. banks would be at a competitive disadvantage vis-à-vis European banks and other international banks that have not implemented Basel III. Even global banks that are implementing them will do so incrementally through 2019.

Mayra Rodríguez Valladares is Managing Principal at MRV Associates, a New York based capital markets and financial regulatory consulting and training firm. She also teaches at The New York Institute of Finance.