Capital Requirements: Another Odd Attempt to Declare Victory on Dodd-Frank

By David Dayen, author of Chain of Title: How Three Ordinary Americans Uncovered Wall Street’s Great Foreclosure Fraud, releasing May 17. Follow him on Twitter @ddayen.

I suppose we’re going to have to deal with half-truths and logical stretches about Dodd-Frank right through until November, but Bernie Sanders’ laser focus on Wall Street has ramped this up of late. The trajectory appears to be: a show of proof of some sort, followed by a blog link from Paul Krugman, at which point the citation hardens into conventional wisdom. This one got rolling by Wonkblog’s Matt O’Brien, and while it has a level of truth to it, I don’t think it reveals exactly what its endorsers think.

O’Brien keys off of the following chart, to show that leverage (I suspect everyone reading this knows what that means, but to be brief, the percentage of the balance sheet funded through borrowing) throughout the financial sector decreased during the recession and kept falling through the recovery.

Now, on the one hand, it’s not surprising that bank borrowing crashed during the, well, crash. But on the other, it’s at least a little surprising that leverage has continued to contract since then despite the fact that the economy’s been expanding and there hasn’t been another crisis. That hasn’t happened at any other time in recent memory.

OK, take a closer look at that chart. The part I bolded for emphasis isn’t true. It has happened at another time in recent memory. It happened, in fact, in 1998, as the chart shows. The chart bizarrely attributes this to the adoption of Gramm-Leach-Bliley, but really it can be explained by a credit crunch, from the East Asian and Mexican crises and the collapsed of Long Term Capital Management, which caused skittish market participants to reduce leverage. The general truism of this chart is that credit crunches cause rapid pullbacks in leverage, whether the economy is in expansion or not (indeed the ’98 leverage reduction came during the best economic growth period of the past 30 years).

I should add that I got Matt to admit this on Twitter last Wednesday, and he never updated the post to reflect that, nor did he changed the sentence “That hasn’t happened at any other time in recent memory.” It’s not even fatal to Matt’s point, but the inability to clean up the hyperbole kind of shows what the priority is here: to cheerlead for Dodd-Frank.

The thing is, you don’t need this chart to tell a story about leverage, and its close cousin, risk-based capital. A Boston Fed report out last week shows largely the same thing; capital and leverage ratios have nudged up since 2010.

Now you can make the argument that leverage is pro-cyclical; when asset prices rise, leverage decreases because those assets are more valuable, and when they crash, leverage jumps. It’s worth pointing out that Dodd-Frank tries specifically to correct for this, with language in Section 616 calling on the Fed to “make such requirements counter-cyclical, such that the amount of capital require to be maintained by a company increases in times of economic expansion and decreases in times of contraction.” (And the Fed has done this with a counter-cyclical buffer.)

But my question is why the many pundits and observers hyping the leverage evidence would solely call it a Dodd-Frank story.

Let’s remember that the Obama Administration worked very hard to keep statutory designations of capital requirements out of Dodd-Frank. Sheila Bair goes into great detail in her book Bull By the Horns about this. Susan Collins (R-ME) put forward an amendment that would set a floor for capital requirements (albeit with vague language: “generally applicable leverage and risk-based capital requirements” is the specific floor in Section 171, which means… whatever the banking regulators want it to mean). “As soon as he got wind of the amendment, Tim (Geithner) visited Collins and pushed back,” Bair writes, “saying that it would hurt smaller banks!” Geithner and the Fed didn’t want Congress having any input on capital requirements, and they go after the Collins provision continually.

Fortunately, they lost the battle, and the Collins amendment passed. But again, it just sets a floor, not a specific number. It also mandates that the SIFIs (systemically important financial institutions) have some manner of capital surcharge, but it doesn’t specify how much bigger it has to be than for non-SIFIs: technically it could be .00000001% higher. The hard numbers got filled in by the international Basel III process, and then deliberations by the Fed.

There were a lot of countervailing pressures on regulators before and after Dodd-Frank with respect to capital. An intellectual movement, bipartisan in nature, coalesced around the idea of capital as a vital and necessary financial reform. Academics like Anat Admati were skillful in challenging regulators to go well outside their comfort zones. They had allies inside the agencies, like Thomas Hoenig at FDIC.

In the end, the Fed tightened leverage and risk-based capital requirements, not to the degree that Admati and her allies wanted, but well beyond initial expectations. But critically, that was their decision to make; they could have done essentially nothing beyond Basel and been perfectly within the confines of Dodd-Frank.

Also, the banking regulators already had the authority to impose capital requirements; Dodd-Frank reshuffled those authorities and perhaps gave the agencies some direction. But the die was already cast. According to informed sources, people like William Dudley at the New York Fed were resolved to raise capital for the largest banks as early as the beginning of 2010, months before Dodd-Frank passed. By that time there were white papers, but remember that Geithner wanted capital out of the bill – Dudley wasn’t influenced by something that wasn’t there. The regulators realized they let things get far too loose before the crisis, and thought the best way to unobtrusively protect the system at minimal public cost was to force the industry to absorb their own losses. And they wanted to keep that prerogative to themselves.

Note that Krugman, who jumped all over O’Brien’s story, hedges his bet by saying that falling leverage was “probably because of Dodd-Frank.” He has to reach for the rule classifying SIFIs to tighter capital restraints to explain the leverage situation. But this is absurd: the SIFI designation presents an incentive to get below the $50 billion asset threshold, as we are now seeing. That’s generally an good thing, but it has nothing to do with leverage – if anything it would increase it for the financial institutions that slide under $50 billion, because they have less restraints. And again, the SIFI premium is discretionary.

Bill Black, in his Bank Whistleblowers Group plan for stiffer prosecution of financial fraud, has as a major plank the imposition of individual minimum capital requirements, which he cites the authority for back to 1989. Black believes regulators could make these so big to prevent financial firms from engaging in particular activities.

The point is that we should not point to falling capital/leverage and praise Dodd-Frank. We should praise individual regulators for using long-held authority, and the outside movement that brought their voices to bear to ensure that the regulators followed through. That’s the real lesson here.

And what does that mean for the future? Well, you would want regulators who would be responsive to that bipartisan movement for capital standards, who wouldn’t supplant that trend with one from Wall Street, who wouldn’t backslide. In other words, personnel as policy, something Sen. Warren has stressed the entire past year. And the candidates for staffing the federal banking agencies should be assessed on that basis.

Finally, it’s important to make clear that a decent leverage ratio is not enough to declare victory in financial reform. If you prevented banks from lending entirely they’d have a leverage ratio of 100%. What we want is a system where productive lending activities are privileged and de facto gambling is wiped out. We want a resilient system where market discipline can allow institutions that make bad decisions to fail, without risking a cascade of other failures. Capital can make all this easier but cannot be seen as a substitute for system design.

And that’s especially true if the capital and leverage standards come in too low, which is currently the case, even if they are working in a modest fashion today. The way we got the successes we have come from regulators mindful of the last crisis being pushed by outside forces. We should want that to continue to work, rather than shouting about triumphs and averting our gaze to something else.