Too Big To Fail Banks Will Kill All Reforms

This article originally appeared in The Daily Capitalist.

You may wipe your brow and say to yourself, "Well, we avoided the Big One this time, let's get back to normal."  After all, we were threatened with the specter of the Great Depression early into the crisis, at least according to Ben Bernanke, and you might think that we dodged that bullet. You would be wrong.

You would be wrong because those trying to run our vast economy have no real understanding of what caused the Great Depression, and they have no real understanding of what caused the Great Recession (Great Depression II if you are in the real estate business). In fact, very little has changed other than the regulatory power grabs by various government entities.

And now the power of Crony Capitalism is aiming full-swing at the various rules and regulations enacted post-Crash. If you are a true Conservative (I'm not) who believes that banks ought to be left alone to do the business of America, then you also would be wrong. Let me back up for a moment.

I am an Austrian theory, free market economic analyst. I believe that most of our problems are created by government interventions in the economy. I think I can prove that as can most Austrian School economists. So, when I say Conservatives are wrong about the banking system, it is because they tend to look at the current situation as being "free market" and government should back off. A fine sentiment, but in fact our financial system is one of the most regulated, tinkered and meddled with sectors of our economy. It is as if these Conservatives dropped in on the middle of the conversation and missed the real gist of the discussion.

Banks are a major problem because government policies made them that way.

Within this context we free marketeers don't have a lot of room to maneuver. Given that, some of these new banking rules aimed at preventing some of these big banks' more egregious behaviors might actually help the situation until (if?) the cavalry arrives. No, I am not advocating  more regulation, but within a fractional reserve banking system with a money printer of last resort (the Fed) we at least ought to try to not go backwards.

Many of these new rules revolve around what is known as Basel III as well as the Dodd-Frank Act. The essence of these rules require lenders to have more capital and liquid reserves and limit their lending activities in the housing market especially.

Capital Requirements

For example, Basel III (Basel Committee on Banking Supervision), the policy-making supranational quasi-regulatory authority that most major countries adhere to, has increased capital requirements for banks:

The officials last year agreed to more than double the minimum common equity requirement for banks to 4.5 percent from 2 percent of assets weighted for risk. Banks will also be asked to maintain a “capital conservation” buffer of as much as 2.5 percent common equity in periods of “excess credit growth,” bringing total common equity requirements to as high as 7 percent of assets weighted for risk. The capital buffer for systemically important firms would come on top of this new standard.

Now the Too Big To Fail banks (that should have failed but for the bailouts) are complaining. Previously such banks were only required to keep a 3% to 4% reserve requirement. The formula is complicated, but there are various tiers of capital requirements each with different capital requirements.

For more detailed information go here.

The TBTF banks have been fighting these rules. One could argue that the market should sort out what the reserve requirements should be, but that isn't going to happen. So at least one should require banks to behave prudently. These new capital requirements act to limit the amount of loans a bank can make because they are required to keep a greater amount of capital or reserves on hand than before.

According to Simon Johnson, the regulators did the very least they could do, hewing close to the wishes of their banking clientele.

What was the banks' response?

"Every dollar of capital is one less dollar working in the economy," the Financial Services Roundtable, a lobbying group of large U.S. financial firms, said in a statement.

The Basel folks called it a "balanced approach," because they believe that the rules will reduce the banks' ability to lend. Which is true, but it misses the mark. The TBTF banks have all the capital they need to lend. But for reasons that escape them, borrowers are few. And, as we know, the Fed-induced credit splurge was responsible for the boom-bust cycle we are now experiencing.

Liquidity Requirements

The next big fight has to do with the "liquidity" requirements of banks. The regulators are requiring banks to have sufficient liquid assets to withstand a run that would last for 30 days. In such an event, the bank must have a certain amount of liquid assets that must stand ready to absorb losses and maintain sufficient capital ratios. And that has to do with the "quality" of the assets they hold as capital. For example Treasurys would be treated as being highly liquid and thus qualify, but FHA advances or AAA securitized debt wouldn't.

If banks fall below the buffer, regulators could force them to hold onto more of their earnings to augment their capital, which means the companies will have less money on hand to pay dividends or offer large compensation packages. Some analysts believe the new standards could essentially force banks to shrink their loan portfolios or shed other assets in order to improve their capital positions.

The TBTF banks don't like this:

“You’re going to end up with 10 percent capital for banks like us,” [JP Morgan Chairman Jamie] Dimon said at the Sanford C. Bernstein & Co. investor conference today in New York. “It will have ramifications on what people pay for credit, what banks hold on balance sheets.”

I think what Mr. Dimon really means is that JP Morgan will be somewhat restricted in financing the next boom-bust cycle, and they won't make as much money at the taxpayers' expense.

Risk Retention Rules

The other thing these banks are complaining about are the risk retention rules in Dodd-Frank. Under these rules, if a lender securitize a home mortgage, it must keep 5% of it. This is a skin in the game rule. The thinking being that lenders will be more careful writing loans if they retain some liability for the loan's success or failure.

There is a big loophole called a "qualified residential mortgage," or "QRM." These are loans which are to be underwritten sensibly. That is they require a 20% down payment, the loan-t0-value ratio cannot exceed 80%, and the debt-to-income ratio cannot exceed 28% at the time the loan is made.

I'm not suggesting the government mandate loan standards, but on the other hand, if I as a taxpayer am forced to bail them out, I think these are sensible loan standards. In fact these were the standards widely used in the "old days" before modern financing techniques were developed (no down, liar loans, low credit scores, ARMs, teasers, subprime MBS, CDO squared, etc., etc.).

Here is the sleazy part. A coalition of  'interested parties' comprised of The Mortgage Bankers Association, the National Community Reinvestment Coalition, the Consumer Federation of America, the Center for Responsible Lending, and the National Housing Conference, have protested these rules:

"What has been proposed essentially creates a separate and unequal system of finance for people of color and for blue-collar, working-class people where regardless of your creditworthiness, of whether you're someone who has a great credit score and pays your bills on time and plays by all the rules, if you're not well-heeled enough to come up with 20% or if you're household debt to income ratios are high … you're going to go into a separate and unequal category of financing where you're going to have to pay more."

I would suggest that this is a blatant attempt to bring politics to bear to the situation. I am sure you are shocked.

Here's the worst of the worst: Barney Frank, the gentleman who co-authored the bill, signed a letter along with other Representatives saying:

"There is evidence that a 20% requirement does not result in sufficiently lower risk to justify the significantly enhanced hurdle to buying a home that this represents."

This is the same Barney Frank who at House Financial Services Committee hearings investigating the soundness of Fannie and Freddie said:

House Financial Services Committee hearing, Sept. 10, 2003:

Rep. Barney Frank (D., Mass.): I worry, frankly, that there’s a tension here. The more people, in my judgment, exaggerate a threat of safety and soundness, the more people conjure up the possibility of serious financial losses to the Treasury, which I do not see. I think we see entities that are fundamentally sound financially and withstand some of the disaster scenarios. .
. .
House Financial Services Committee hearing, Sept. 25, 2003:

Rep. Frank: I do think I do not want the same kind of focus on safety and soundness that we have in OCC [Office of the Comptroller of the Currency] and OTS [Office of Thrift Supervision]. I want to roll the dice a little bit more in this situation towards subsidized housing. . . .
* * *
Rep. Frank: Let me ask [George] Gould [President of Freddie] and [Franklin] Raines [President of Fannie]:on behalf of Freddie Mac and Fannie Mae ,do you feel that over the past years you have been substantially under-regulated?
Mr. Raines?
Mr. Raines: No, sir.
Mr. Frank: Mr. Gould?
Mr. Gould: No, sir. . . .
Mr. Frank: OK. Then I am not entirely sure why we are here. ... I believe there has been more alarm raised about potential unsafety and unsoundness than, in fact, exists.

The last I heard, that little roll of the dice cost taxpayers $42 billion.

History Repeats Itself

Nothing has changed. Politicians will not change.  The Fed will not change. It is impossible to get real reform through Congress. It seems to matter not whether we have Republicans or Democrats in control. Neither Basel III nor Dodd-Frank are written in stone.  By the time the TBTF banks and their lobbyists get through with these rules, banks will be relatively free to pursue lending practices that existed before the Crash. The powerful Washington-Wall Street Financial Complex is in control of the financial system. We need radical, free market reform.


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