At Senate Banking Hearing, Brown To Call For Simplified, Strengthened Standards That Ensure Wall Street Megabanks Have Capital Needed To Prevent “Too Big To Fail”

Along with Republican Sen. David Vitter, Brown Has Repeatedly Called on Bank Regulators to Raise Capital Requirements for Largest Megabanks to Ensure they Have Equity to Withstand Market Shocks

WASHINGTON, D.C. –During a hearing today, the Senate Banking Committee will examine efforts by U.S. banking agencies to adopt new bank capital standards that ensure financial institutions have the equity needed to back up their lending, investments, and trading practices. U.S. Sen. Sherrod Brown (D-OH), who chairs the Committee’s panel on Financial Institutions and Consumer Protection, will renew his call to address the “Too Big to Fail” problem by ensuring that the nation’s largest banks have higher capital standards and helping smaller community banks compete.

“As Wall Street megabanks have become more complex and less transparent, so have the rules that govern them. This puts taxpayers on the hook for risky bets,” Brown said. “That’s why I’m working to streamline and strengthen capital standards, to ensure that banks have adequate amounts of their own cash on hand and aren’t left to rely on Ohio families for financial support.”

Last month, Brown and Sen. David Vitter (R-LA) urged the Federal Reserve, the Office of the Comptroller of the Currency (OCC), and the Federal Deposit Insurance Corporation (FDIC) to simplify and strengthen capital rules for banks. In August, Brown and Vitter, who are both members of the Senate Banking Committee, sent a letter to the Federal Reserve urging the agency to raise the capital requirements for the largest megabanks, in order to prevent any one financial institution from becoming “Too Big to Fail.”

Brown is the sponsor of the SAFE Banking Act, which would require Wall Street megabanks to meet a 10 percent leverage ratio of common equity to total assets, including those held off-balance sheet. In August 2011, Brown chaired a subcommittee hearing entitled “Debt Financing in the Domestic Financial Sector.”

Witnesses at today’s hearing included:

  • Michael S. Gibson, Director of Banking Supervision and Regulation, Federal Reserve;
  • John Lyons, Chief National Bank Examiner, OCC; and
  • George French, Deputy Director, Division of Risk Management Supervision, FDIC.

Below is Brown’s statement that was submitted for the record.

Capital rules simply require banks to fund themselves with their own money – usually in the form of equity – instead of other people’s money, borrowed from the markets, regulators, or U.S. taxpayers.


Prior to the financial crisis, financial institutions relied upon too much borrowed money and flawed models that used smoke and mirrors to make their investments appear riskless. But they were not riskless.  And when their assets declined by even the smallest amount, they were unable to pay their debts. As a result, the taxpayers were forced to step in and cover Wall Street’s risky bets.


I am encouraged that there is now broad, bipartisan agreement among the members of this committee that adequate bank capital is an essential tool for protecting the financial system. Basel III is clearly an improvement over Wall Street’s old way of doing business, but I question whether the new rules get it right.


First, are we properly defining and measuring capital?

Clearly there were shortcomings in the regulators’ measurement of capital prior to the crisis. At the height of the crisis, seemingly healthy institutions had respectable levels of regulatory capital. According to the FDIC’s Thomas Hoenig, in 2007, the 10 largest banks had average risk-based capital ratios of 11 percent. But their tangible equity ratios of were about 2.8 percent. As a result, markets lacked confidence in these institutions.


According to Federal Reserve Governor Dan Tarullo, this was because investors ignored the more exotic instruments that qualified as capital and instead looked at tangible equity. This experience provides strong support for the view that we should focus on pure equity as a measure of a bank’s health.


Second, are the levels sufficient to lessen the likelihood and severity of future crises?


The Bank of England’s Andy Haldane estimates that global banks hold assets with average risk-weighting of 40 percent, meaning that the 10 percent risk-weighted Basel III ratio would amount to leverage or 25-to-1. Were a megabank’s assets to decline by 4 percent under that scenario, it would become insolvent.


A number of studies have shown that the optimal risk-weighted assets to capital ratios are considerably higher than those contained in Basel III. Banks had considerably higher capital before the creation of the financial safety net. So we know that the international 3 percent leverage ratio is much too low – prior its failure, Bear Stearns had leverage of thirty-three33 to one.


The U.S. benchmark of 4 percent is also too low – Haldane estimates that institutions would have needed a minimum 7 percent leverage to have survived the financial crisis. My legislation, the SAFE Banking Act calls for 10 percent tangible equity to total assets, not adjusted for risk and including those held off-balance sheet.


Third, have we created a system of complex rules on top of complex banks that are excessively complex and opaque?


The six largest banks currently have a combined 14,420 subsidiaries. Haldane has estimated that an average large bank would have to conduct more than 200 million calculations in order to determine their regulatory capital under the Basel II framework. Several million scenarios could arise from a large bank’s trading book alone.


The evidence suggests that these complex and highly calibrated measurements do not work. Haldane has found that simple measures of equity and leverage actually have predictive value that is ten times greater than that of complex risk-weighted asset measurements.


And finally, are we too focused on community banks or traditional insurance companies, and not enough on Wall Street megabanks?


According to Dr. Hoenig, in 2009, the 20 largest financial institutions on average funded themselves with a mix of 3.5 percent equity capital, as compared to an equity capital ratio of 6 percent held by the second tier of institutions. 


These megabanks can use more leverage because implicit government support, where the market assumes that the government will step in to prevent them from failing, provides subsidies and it puts true community banks – those with less than $10 billion in assets – at a disadvantage. These incentives can be counteracted by requiring megabanks to increase their capital buffers.


I agree with Governor Tarullo that the proposed surcharges for the largest institutions are at the low end of the scale. We should do more to impose costs that will discourage banks from becoming “too big to fail.”


This will benefit taxpayers, and it will benefit the community banks that compete with unfairly subsidized megabanks. These are all important questions, because we must ensure that Wall Street has a prudent amount of its own money to cover its losses. 



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