Capital Idea

Financial regulation in the U.S. is turning out to be the gift that keeps on giving. Hopes of repealing Dodd Frank could turn out to be a cruel bait and switch for the major U.S. banks. The major players in this drama are Representative Jeb Hensarling (R/TX), FDIC Vice Chairman Thomas Hoenig and outgoing Fed Governor Daniel Turullo.

In late 2016 the house banking committee passed the Financial Choice Act, which is the their version of “repeal and replace” for Dodd Frank. The basic outline of the bill is as follows: If the banks keep 10% CET1 to total (leverage?) assets they will be exempted from some regulatory standards. The bill also repeals the Volker Rule. The bill is wildly unpopular with democrats and generally viewed as more of a messaging tool i.e., conversation-starter for negotiations on changing or repealing Dodd Frank.

FDIC Vice Chairman Hoenig recently put forth a proposal (“term sheet”) that would have the banks create two interim holding companies (IHC) below the parent financial holding company (FHC). One IHC would be for commercial banking activities and the other for non-traditional activities, mostly related to investment banking. Both IHC would be separately capitalized and inter-IHC transactions would be prohibited. In essence a 21st century Glass Steagel as our friends at Cadwaladar point out:

“The enhanced restriction on affiliate transactions and the separate capitalization requirements effectively mean that the banking and nonbanking arms of the FHC would be run as two largely standalone entities operating under a common brand.”

Both IHC would be required to meet a “10% leverage” test and in exchange would be exempted from many of the current regulatory metric standards (CET1, SLR, LCR, Living Wills, and certain Stress Test requirements). The banks would be given three years to migrate to the proposed structure. Again is this an opening gambit to future negotiations or end-state alternative regulatory structure?

Next we have the exit of the regulatory hawk Fed Governor Daniel Turullo. His departure probably means a significant foot off the gas pedal on bank regulation. Turullo’s reign, unofficial as it was, which makes it even more impressive, brought, among other things, ever-stricter CCAR and Living Will standards and capital surcharges for the major U.S. banks. His absence will create at least a temporary vacuum in the bank regulatory space, which may end up being the most significant regulatory relief for the banks in 2017.

Not everyone is jumping on the “capital is king” bandwagon. There was a recent op-ed in the Wall Street Journal that took the other side of this argument[1]. Tim Congden and Steve H. Hanke wrote that excessive capital requirements at banks would result in the economy sliding back into the conditions experienced during the great recession. Their thesis is that banks can meet ever increasing capital ratios two ways: raise capital or cut assets (which is exactly what J.P. Morgan did to reduce the Fed’s 2015 capital surcharge). The bank assets that would be reduced are comprised of loans to the industrial and commercial sectors of the economy. Lower lending activity equals reduced access to credit thus damaging the economy.

Clearly the view in DC is that capital is the key to bank stability. The more capital the banks have the more stable they will be[2]. There are unintended consequences flying off in all directions with these proposals.

First there would be a further widening of the differences in standards for US and International banks. This would result in making it harder for the US banks to compete with the foreign banks. Then there is the Congden/Hanke argument that increased capital requirements for the banks would plunge the economy into a deep recession. More capital also means the banks have to generate higher revenues to maintain, or increase, their ROE. Most of the banks are already struggling to make 10% ROE.

Finally there is the FDIC proposal, which really only affects about four of the major banks: JPM, Citigroup, BAML and Wells Fargo[3]. Morgan Stanley and Goldman Sachs aren’t really banks, though they would probably benefit from a leveling of the playing field with the big banks (who have been making inroads into their prime brokerage market share). The FDIC proposal seeks to ring-fence a separately capitalized investment banking entity so that it can fail without impacting commercial and retail bank customers. However one has to ask, even with separately capitalized investment bank would the government not bail them out in a crisis? It doesn’t take a bank failure to destabilize the world economy (e.g., Lehman Brothers). It seems like a lot of effort that does nothing to solve for Too Big To Fail.

Admittedly it is early days for both these proposals, so how much should we worry about this? Congress isn’t looking too effective right now at getting anything passed. Dodd Frank reform, or repeal, is way back in the line behind tax reform, infrastructure spending, etc. The FDIC idea would also take an act of Congress and cooperation from the banking industry. Not such a high probability at the moment. Still the “capital is king” movement bears watching. Bank regulation, in the form of Dodd Frank but more importantly Basel III, has had a significant impact on banks’ financing of hedge funds. These proposals by the Congress and the FDIC would ratchet up the capital requirements at the major U.S. banks. Higher bank capital requirement will result in a further reduction in balance sheet and financing available to hedge funds. Not such a capital idea.

[1] “More Bank Capital Could Kill the Economy” by Tim Congdon and Steve H. Hanke, The Wall Street Journal, March 13, 2017

[2] We haven’t even discussed Minnesota Fed President Neel Kashkari’s call for bank capital levels of more than 20%. Yikes!

[3] It’s probably a good idea to keep the retail guys separate from those risky IB folks.

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