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Tuesday, April 9, 2013

Addressing Systemic Risk By Increasing Capital-Reserve Requirements

Although the Dodd-Frank Wall Street Reform Act includes significant reforms such as liquidity standards, stress tests, and resolution plans, the additional capital requirements (i.e., the SIFI surcharges) may not be sufficient should there be another financial crisis like the one in 2008. A study by the Federal Reserve Bank of Boston found that even the additional capital requirements in Dodd-Frank would not have been enough for eight of the 26 banks with the largest capital loss during that crisis. As overvalued assets, such as subprime mortgage-backed derivatives, plummet in value, banks can burn through their capital reserves very quickly. A frenzy of short-sellers can quicken the downward cycle even more. This raises the question of whether relying even in part on additional capital requirements as a bulwark is smart. It is not as though the financial crisis of 2008 was the crisis to end all financial crises.
With the $6.2 billion trading loss at JPMorgan Chase in the hindsight, Sen. Sherrod Brown (D-Ohio) and Sen. David Vitter (R-La) in the U.S. Senate proposed a bill that would require banks with more than $400 billion in assets to hold at least 15 percent of those assets in hard capital. The two senators meant this requirement to encourage the multi-trillion-dollar banks to split up into smaller banks. The Senate had recently voted 99-0 on a nonbinding resolution to end taxpayer subsidies to too-big-to-fail banks. Accordingly, the U.S. Senate had Wall Street’s attention. Considering that the U.S. House of Representatives was working on legislation to deregulate derivatives, the chances that the U.S. Government would stand up to Wall Street even to the too-big-to-fail systemic risk were slim to nil. Indeed, the U.S. Department of Justice’s criminal division had been going easy in prosecuting the big banks for fraud out of fear that a conviction would cause a bank collapse.
The senators’ strategy of going about breaking up the biggest banks indirectly can be critiqued on at least two grounds. First, should one or more of those banks decide to go with the 15% requirement rather than break up into smaller firms, even the additional capital might not be enough to protect a bank during a financial crisis. The study discussed above suggests as much. Second, even if the additional requirements would turn out to be sufficient in a crisis, the approach would obviate a decision by the government on whether systemic risk justifies a cap on how large banks can get. The question is similar to that concerning the Sherman Anti-Trust Act. Should systemic risk be added to monopoly as justifying government intervention in limiting private property? I contend that even the actual harm that the financial crisis of 2008 wrought on the U.S. economy justifies such intervention under the rubric of systemic risk.


Sources:

Eric Rosengren, “Bank Capital: Lessons from the U.S. Financial Crisis,” Federal Reserve Bank of Boston, February 25, 2013.

Zach Carter and Ryan Grim, “’Break Up the Banks’ Bill Gains Steam in Senate As Wall Street Lobbyists Cry Foul,” The Huffington Post, April 8, 2013.