The RBDA strongly supports comprehensive financial regulatory reform, including efforts to end the taxpayer bailout of financial institutions viewed as “too big to fail.” In addition to requiring improved transparency, meaningful regulatory reform must establish effective barriers to firms ever becoming “too big to fail” or otherwise posing a risk to the financial system; conversely, any effective regulatory system cannot implicitly induce behaviors that contribute to such a risk. Regulatory reform also must not create a two-tier system that favors the largest institutions. While the Restoring American Financial Stability Act of 2010, which is before the Senate, (the “Bill”) is an improvement over current law in some respects, certain of the Bill’s provisions are ineffective barriers to risky growth, and others either implicitly or expressly encourage such growth by clearly signaling to the market that the largest firms and their creditors will be protected from the consequences of excessive risk taking. By giving that signal, the Bill favors large Wall Street firms at the expense of Main Street. Creditors doing business with the largest firms will know that they are not at risk for loss and will prefer doing business with Wall Street, giving the largest firms favorable terms in return for an implicit Federal guarantee. This gives the largest firms a competitive advantage and frees them from the discipline of the market. As a result, the Bill would actually encourage further concentration in the financial industry, resulting in risky behavior and moral hazard. This works at cross-purposes to the underlying rationale of the Bill and to the needs of the American economy.
II. INEFFECTIVE BARRIERS TO RISKY GROWTH
There are two basic causes of the current economic crisis – excessive leverage and excessive concentration. The Bill does not go far enough in addressing either. Minimum Capital/Maximum Leverage Requirements The current regulatory framework permitted the explosive growth of large, highly leveraged financial firms over the past decade. Congress must create a system that provides incentives for sound management practices and imposes specific and meaningful costs on engaging in the types of activities that contributed to the financial crisis. Minimum capital requirements and maximum leverage limitations are the key. While the Bill acknowledges that minimum capital and maximum leverage requirements “may” play a role, it leaves open the question of whether and to what extent such requirements will be brought to bear. Instead, it provides that the “recommendations” to be made by the new Financial Stability Oversight Council “may” include risk-based capital requirements and leverage limits. In other words, the Bill leaves to the regulators the question of whether and to what extent capital requirements and leverage limits will be imposed. This is the system that was in place and failed, at the beginning of the financial crisis. Congress instead should expressly and specifically require that financial firms meet stricter capital and leverage requirements as they grow or engage in trades that involve heightened risk. This would unambiguously discourage firms from becoming too big to fail and would reduce the probability that financial firms experience financial distress, either through capital depletion or a run by creditors. The Wall Street Reform and Consumer Protection Act of 2009 (the “House bill”) presents a better model than the Bill on this point, but even that does not go far enough. Under the House bill, the largest financial holding companies are specifically required “to maintain a debt to equity ratio of no more than 15 to 1.” Regulators are then charged with promulgating procedures and timelines pursuant to which any such companies that are out of compliance will be required to reduce their ratios. Similarly, while the House Bill allows regulators to specify the ratio of tangible equity to total assets at which such a financial holding company will be deemed to be “critically undercapitalized,” Congress limits the regulators’ discretion by specifying that the level of tangible equity required shall be no less than 2% of total assets and (unless otherwise required by the 2% rule) no more than 65% of the required minimum level of capital under the leverage limit. Although the House bill specifies minimum standards, it does not require that the standards be graduated so that the capital requirements and limits on leverage increase as a firm gets larger. Such legislative clarity in connection with minimum capital and maximum leverage requirements is necessary to effectively remedy the deficiencies of the existing regulatory framework. Excessive Concentration and Risk – The Volcker Rule Excessive concentration of liabilities is another weakness in the current system, as is excessive risk-taking. The Bill attempts to deal with those problems, in part, by including a version of the “Volcker Rule.” As proposed by the President, the Volcker rule consists of two parts. It would: 1. Limit the Scope – No bank or financial institution that contains a bank could own, invest in or sponsor a hedge fund or a private equity fund, or proprietary trading operations unrelated to serving customers for its own profit. 2. Limit the Size – Building on an existing limitation on consolidations in the banking industry as they relate to deposits, the rule would prohibit consolidations where the consolidated entity would have more than ten percent market share of the liabilities of the largest financial firms. Neither aspect of the Volcker Rule would limit the credit exposure of large firms to counterparties or limit the size of an institution, unless then increased size was due to a consolidation. The Bill includes what appears to be the least nuanced version possible of the Volcker Rule, flatly prohibiting “proprietary trading by an insured depository institution, a company that controls an insured depository institution or is treated as a bank holding company . . . and any subsidiary of such institution or company.” It would prohibit any institution from acquiring or disposing of “financial instruments . . . for the trading book” of such institution, without providing any real clarity with respect to what “the trading book” is intended to encompass, or whether there are any reasonable limits on what constitutes a targeted “financial instrument” (other than an exception for certain U.S. obligations and municipal bonds). Further, much as it does with the minimum capital and maximum leverage requirements, the Bill on this point eventually defers almost entirely to regulators and thus provides no certainty to the market or market participants, large or small. The legislation expressly subjects itself to the “recommendations and modifications of the Council.” The content of both the definitions and the substantive provisions of the legislation are subject to the review of the Financial Stability Oversight Council; and “the appropriate Federal banking agencies” are then directed by the Bill to issue regulations implementing any resulting recommendations or modifications. The RBDA supports a clear limit on proprietary trading that recognizes the legitimate purchase and sale by a firm of securities and clearly delineates what is and is not truly “proprietary trading.” As the RBDA has stated in the past, instead of categorically prohibiting all banks from participating in certain transactions, Congress should adopt legislation that specifically promotes sound management practices, and provides meaningful disincentives in connection with the types of activities and risky growth that precipitated the financial crisis. Narrowly focused restrictions on proprietary trading, when applied to firms that engage in a particularly high volume of such trades, may meet those criteria; however, the Bill’s blanket ban on proprietary trading fails to address the predominant causes of the financial crisis while simultaneously imposing too broad a restriction on a business practice that is hard to define and not always high risk. The other aspect of the Volcker Rule, limiting the size of consolidated institutions is good as far as it goes. However, it does nothing to address the current size of institutions or their growth outside of consolidations and, as we note elsewhere in this policy paper, the Bill encourages such growth. Further, unlike the House bill, the Bill does not place limits on the credit exposure of large firms to specific counterparties. The House bill would set a maximum limit on the credit exposure of large financial institutions to unaffiliated companies. This would be an additional protection for the financial system.
III. INSTITUTIONALIZING “TOO BIG TO FAIL”
Narrowed Federal Reserve Focus One of the Bill’s signals to the market that the largest firms will implicitly be protected from the consequences of their excessive risk taking is the narrowing of the Federal Reserve’s regulatory focus to just those financial institutions having $50 billion or more in total consolidated assets. Such a regulatory shift will be interpreted by market participants as an implicit guarantee of government support should any institutions in that select group find themselves at risk of failure. That implicit guarantee will undermine the position of smaller firms that do not provide a market systemic risk and will encourage large firms to become larger. However, as the RBDA has stated previously, the financial system will operate efficiently only if large firms—even those with more than $50 billion in total consolidated assets—are held accountable for the consequences of poor management and risky behavior. Any alternative to that accountability, even an implicit alternative, will undoubtedly induce increasingly risky behavior on the part of the largest firms, undermine the competitive position of smaller firms, and ultimately result in a burden on taxpayers. In addition, the proposed narrowing of the Federal Reserve’s supervisory perspective to only the largest of the large institutions makes for bad regulatory policy even apart from the potential market effects of the institutionalization of “too big to fail.” The tacit assumption underlying such a change is that the Federal Reserve can just as effectively perform its mandated role as the central bank of the United States of America while interacting with only the largest Wall Street firms. However, as the recent financial crisis has clearly demonstrated, the financial system in the United States extends far beyond Wall Street. It is dangerously myopic to assume that by supervising only the few largest, and largely New York City-based, financial firms, the Federal Reserve will be able to sufficiently protect the entirety of the diverse national financial system from future crises. Orderly Liquidation Fund Unlike the implicit message of the proposed narrowing of the Federal Reserve’s regulatory focus, the orderly liquidation fund is an explicit guarantee. The establishment of this fund will promote excessive risk taking and moral hazard among the firms paying into the fund and deemed too big to fail while putting taxpayers on the hook for future federal government bailouts because the fund is only a fraction of what a future bailout will cost. As part of the legislation’s design for “orderly liquidation,” it establishes within Treasury a $50 billion “orderly liquidation fund,” to be available to the FDIC to pay the cost of any actions authorized by the Bill in connection with the FDIC’s liquidation authority. Such authorized actions include, for example, the payment of “all valid obligations of the covered financial company that are due and payable” at the time the FDIC is appointed as receiver. Consequently, under the Bill, if the Secretary of the Treasury determines that a particular financial institution is big enough and in enough trouble to be systemically dangerous, the FDIC can tap into that $50 billion pool and begin to pay the firm’s creditors. The firm’s obligations will have the backing of the federal government. Because of this guarantee, creditors will favor the largest firms and at the expense of smaller ones. This undermines the competitive position of the smaller firms, relieves the largest firms of market discipline and further incentivizes precisely the type of risky growth that effective regulatory reform should discourage.
IV. CONCLUSION
Congress must take advantage of this opportunity to effectively address the weaknesses in the existing regulatory system that contributed to the most significant financial crisis in decades. In addition to requiring improved public transparency of a securities dealer’s books, any meaningful regulatory reform must both establish effective barriers to firms becoming “too big to fail” or otherwise threatening the financial system, and avoid incentivizing behaviors that contribute to such a threat. And Congress’s top priority must be to articulate a clear policy against the taxpayer bailout of large financial institutions. The Bill does not accomplish either objective. The provisions of the Bill that relate to minimum capital/maximum leverage requirements and that would enact the Volcker Rule are ineffective barriers to risky growth as proposed. Moreover, the Bill itself ultimately encourages such growth by creating a two-tier system that clearly signals to the market that the largest firms—and their creditors—will be protected from the consequences of those firms’ risky behaviors.
