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The New York Times - The Answer to Too Big to Fail?

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By Vikas Bajaj

Senators Sherrod Brown, D-Ohio, and David Vitter, R-Louisiana, have a new bill that would make banks keep much higher levels of capital. Not surprisingly, representatives for the financial industry are already claiming that such a requirement would ruin the economy.

A draft of the Brown-Vitter bill, which was leaked to Quartz last week, offers a simple and elegant solution to the "too big to fail" problem by requiring all banks to have capital equal to 10 percent of their assets. The measure would also force regulators to impose additional capital requirements on banks with assets of more than $400 billion; that additional capital would increase with the size of the bank, but the total would always be less than 15 percent.

Forcing the banks to hold more capital makes sense because it makes them less dependent on government bailouts during a crisis. Furthermore, banks are less likely to make brazen gambles when they have their own shareholders' money at stake than when they are primarily betting with the money of depositors, bondholders and taxpayers.

Today most banks have capital that is far below the levels proposed by Mr. Brown and Mr. Vitter. Global banking regulators on the Basel committee, which is working on new capital rules, have proposed setting minimum capital ratios at just 8 percent. Moreover, Basel's ratios are calculated using something known as risk-weighted assets. What that means is banks effectively hold less capital against assets considered less risky and more against capital deemed to be very risky. That may sound reasonable, but as the implosion of supposedly triple-A rated mortgage bonds during the crisis showed, it's difficult to know with certainty which assets are safe and which are not.

Banks, of course, hate the idea of higher ratios because it reduces how much money they make on each dollar of capital. Think of capital as the money you put down to buy a house. If you buy a house for $100,000 and only put down $5,000, when you later sell that house for, say, $120,000 you will have made a profit of $20,000, or four times your initial investment. But if we take the same example and require you to put 20 percent down, or $20,000, your profit would amount to only 100 percent of your starting capital.

But banks don't like to lead with the less-profitable argument. Instead they tend to argue that higher capital ratios would hurt the economy by making loans more expensive or difficult to get. On Wednesday, a group that represents banks, The Clearinghouse Association, put out a study that argues that a 3 percent increase in the capital ratio would lead to a decline in the gross domestic product of more than 2 percent.

Numerous economists have soundly refuted such industry-sponsored studies. In their recent book, "The Bankers' New Clothes," Anat Admati, a professor of finance and economics at Stanford, and Martin Hellwig, director of the Max Planck Institute for Research on Collective Goods, convincingly show how raising capital would lead to a safer and healthier banking sector "at essentially no cost to society."

There's an obvious parallel, here, to wealthy individuals who oppose high-end tax hikes on the grounds that they slow growth, rather than owning up to the fact that they want to keep more of their money.

It's unclear if the Brown-Vitter bill will even get a vote on the Senate floor. Mr. Vitter's office believes that the banking lobby leaked the draft in an effort to ruin its chances. But even if it will face tough political odds, the bill is important in that it offers an opportunity for Washington to engage in an essential economic debate.

This blog post has been revised to reflect the following correction:

Correction: April 10, 2013
A previous version of this post miscalculated the profit in the house-buying example contained in the fifth paragraph.


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