Dear regulators: Don’t cut big banks’ capital

The U.S. banking agencies are proposing that the eight U.S.-based global systemically important banks should reduce their capital by $121 billion — that the banking system would be stronger and more resilient with this reduction in capital.

This would be the result of a plan, first introduced this spring, to ease leverage ratio requirements for the country’s largest institutions.

In other words, 10 years after the financial panic, the banking agencies now appear to believe the stronger capital requirements that were implemented in response to the financial crisis should be reduced.

What in the world are they thinking?

When I speak with banking agencies in Washington, I have suggested to them that banking supervision should return to the basics of safety and soundness as the foremost priority. Protection of the Deposit Insurance Fund was at one time the battle cry of banking. Those who were around in the late 1980s and early 1990s when oil went to $10 a barrel and the bottom fell out of real estate values can remember the special assessments banks and thrifts paid to prop up the funds that were being depleted by closing banks and thrifts.

I argue that compliance has now taken too much of those federal banking agencies’ attention — and we have lost the overriding importance of a safe and sound bank as the priority.

The Federal Deposit Insurance Corp. is divided into two divisions — risk management supervision, which focuses on safety and soundness, and depositor and consumer protection, which focuses on consumer compliance. Organizationally, these two appear to have equal footing. During the debate on the Dodd-Frank Act and the creation of a new mandate and agency dedicated solely to consumer protection, many critics feared that consumer compliance could trump safety and soundness.

Many would argue that has happened. Louisiana a few years ago had a slow-developing flood of the Mississippi River coming south. It gave everyone time to see the flood coming and plan for it, but when bankers here wanted to have the ability to contact large customers to mitigate potential losses against possible flooding — those credits posing the greatest risk to the safety and soundness of the bank — they were told by the FDIC that if they did that they would be subject to fair-lending accountability if all customers were not treated the same, regardless of risk to the bank.

Bankers did not have the luxury of time with the floodwaters coming to be able to assure all customers could be served. As a banker what would you do? Keep the bank itself safe or fear a fair-lending violation and do nothing?

One of the curious arguments that proponents of this proposal make is that leverage ratios lead banks to take on more risk. Proponents have asserted that “leverage ratios are poor predictors of bank failure, and the New York Fed recently published an analysis finding that binding leverage ratios lead banks to take on more, not less risk.” The idea seems to be that “the same amount of capital to be held against a U.S. Treasury security as a subprime 30-year loan” is too taxing for the risk systems of these megabanks. Yet this argument essentially says that big banks can’t be expected to have the controls and processes in place so that they know what they are doing. They can’t possibly keep track of their lending risk. In other words, they are too big to manage.

But the federal banking agencies also have supervisory responsibility over these large institutions. Are they unable to assess the risk of these banks? Do they not have in place systems to monitor the risk profiles of these institutions? If the banks and the banking agencies are not able to monitor and contain the risk in these banks, then the industry has bigger problems than many of us thought 10 years after the crisis.

The argument by supporters that “leverage ratios are poor predictors of bank failure” is the real head-scratcher. We all know these institutions will not be allowed to fail. But when the next government rescue is needed, real loss absorbing capital is all that stands between the bank and the U.S. taxpayer. There are other predictors of extreme bank distress that banking supervisors have that can give public confidence, and yet when needed, the current leverage ratio will be a buffer against the taxpayer — though it won’t be as large with this ill-considered proposal.

Another argument is that higher capital reduces economic activity — or that high capital reduces economic growth. But this suggests, counterintuitively, that weak institutions lend more. Then-FDIC Vice Chairman Thomas Hoenig published data in May of 2016 on this issue, demonstrating that banks with stronger capital lend more than those with weaker capital positions. According to that data, noncommunity banks with a Tier 1 leverage ratio of less than 8% had a 26.7% decrease in total loans to average assets from 2004 through 2014. Banks with a Tier 1 leverage ratio greater than 12% had an increase in total loans to average assets of 6.6%.

It’s also curious that today, with the economy and banks doing so well, it is argued that the current capital requirements are harming the big banks and the economy. But you will never convince the broader banking industry that strongly capitalized banking is not better for the economy and the bank.

What the public wants, and I hope the banking industry wants, is for all banks to have the quantity and quality of loss-absorbing capital necessary for when the next crisis occurs. Because it will happen.