Basel, Tomato, And Mozzarella

By Simon Johnson
The bank lobbyists have a problem.  Last week, they lost a major battle on Capitol Hill with the failure to suspend implementation of the new cap on debit card fees.  Despite the combined efforts of big and small banks, the Corker-Tester bill attracted only 54 votes in the Senate – when it needed 60. 
On debit cards, the retail lobby proved a surprisingly effective counterweight to the financial sector.  On the next big issue, the bankers have a different problem: it’s highly technical, more within the purview of regulators than legislators, and often perceived as boring.  Or, as one bank executive put it to Reuters, speaking of the capital requirements agreed between countries in the so-called Basel III framework,
“When you do mention Basel, your average member of Congress thinks ‘that pairs well with tomato and mozzarella.’”
While the bankers were busy rallying their forces to fight on debit cards – and using up valuable time in Capitol Hill lobbying meetings on that topic – they received a bucket of cold water from Fed Governor Dan Tarullo, who told them in a high profile speech on June 3 that the additional capital requirements for systemically important financial institutions (SIFI) could be as high as 7 percent – or roughly doubling what is required in under the Basel III agreement as the equity capital level for all banks (http://www.federalreserve.gov/newsevents/speech/tarullo20110603a.htm; pdf version is here, http://www.federalreserve.gov/newsevents/speech/tarullo20110603a.pdf).  In news coverage, the Federal Reserve appeared to quickly backtrack, saying that the additional SIFI capital requirement would not be more than 3 percent – but that is still 3 percent more than big banks were hoping (these percentages are relative to risk-weighted assets).
According to Reuters, the big banks will be using four main arguments to press their case on Capitol Hill against additional SIFI capital requirements.  None of these arguments are boring – all of them are wrong in interesting and informative ways.
First, “Holding capital hostage will hurt the struggling economy because it will mean fewer loans at a time when lending is already depressed”.  But capital requirements do not hold anyone or anything hostage – they merely require financial institutions to fund themselves more with equity relative to debt.
Capital requirements are a restriction on the liability side of the balance sheet – they have nothing to do with the asset side (i.e., in what you invest or to whom you lend).  There is a great deal of confusion about this point on Capitol Hill and whenever bankers (or anyone else) talk about “holding” capital, they are reinforcing this confusion.  This is not about holding anything – it is about funding relatively more with loss-absorbing equity and relatively less with debt.  More equity for Systemically Important Financial Institutions means that they can absorb more losses before they turn to the taxpayer for help; this is a good thing.
The idea that higher capital requirements will increase funding costs for banks or cause their balance sheets to shrink or otherwise contract credit is a hoax – and one that has been thoroughly debunked by Anat Admati and her colleagues (here’s the standard reference, which everyone in the banking debate has read by now).  After a blistering campaign, Professor Admati is now taken very seriously in top policy circles – including membership in the FDIC’s Systemic Resolution Advisory Council, which meets for the first time next week.
Professor Admati also has a new public letter to the board of JP Morgan, where management opposes higher capital requirements, pointing out that these requirements would – on top of all the social benefits – also be in the interests of JP Morgan shareholders.  The bankers are not winning this argument on its intellectual merits. 
The second banker argument is apparently, “Requiring massive capital buffers is an admission by regulators that last year’s Dodd-Frank financial reform law does not accomplish its goal of reducing risk.”
This is a complete rewrite of history.  During the Dodd-Frank debates last year, Treasury and leading voices on Capitol Hill – including bank lobbyists – said that it would be a bad idea for Congress to legislate capital requirements.  The line was that these should be set by regulators, after the Basel III negotiations were complete.  This is the appointed moment and Mr. Tarullo is the relevant official – he is in charge of this issue within the Federal Reserve and is also one of the world’s leading experts on capital requirements.  But now the banks want to say that this is not his job, as authorized by Dodd-Frank.  This argument will not fly, except with lawmakers who are looking for any excuse.
Third, “If banks have to hold on to capital instead of making loans, borrowers will turn to the “shadow banking sector” that has little to no oversight.”  There is an important point here, but it is not what the bankers want you to focus on.
The “shadow banking sector” grew rapidly in large part because it was a popular way for very big banks to evade existing – and relatively low – capital requirements pre-2008.  They created various kinds of off-balance sheet entities funded with little equity and a great deal of debt, and they convinced rating agencies and regulators that these were safe structures.  Many of these funds collapsed in the face of losses on their housing-related assets, which turned out to be very risky – and there was not enough equity to absorb losses.
It would be a disaster if this were to happen again, but it is also highly unlikely that Mr. Tarullo and his colleagues will allow these shadows to develop without significant capital requirements. Sebastian Mallaby, who has studied carefully hedge funds and related entities, argued correctly last week in the Financial Times that it would be straightforward to extend higher capital requirements so as to cover shadow banking (http://www.ft.com/intl/cms/s/0/0619d474-9147-11e0-9668-00144feab49a.html).
Fourth, “Tough U.S. standards will hobble banks against international competitors, making the United States a less desirable place to do business.”
But banking without sufficient equity capital is like an industry that emits a great deal of pollution (a point made by Andrew Haldane at the Bank of England; http://www.bankofengland.co.uk/publications/speeches/2010/speech433.pdf ).  Do you really want this activity in your country, irrespective of what anyone else is doing around the world?
If China, India or any other country wants to produce electricity using a technology that severely damages local health, why would the United States want to do the same?  And if the financial pollution floats from others to the U.S. through cross-border connections, we should take steps to limit those connections.
Basel is boring, without doubt.  But it is important.  The incorrect, misleading, and generally false arguments of bank lobbyists should be rejected by regulators and legislators alike.
An edited version of this post appeared this morning on the NYT.com’s Economix blog; it is used here with permission.  If you would like to reproduce the entire post, please contact the New York Times.