Yesterday, the Treasury Department released its vision for reforming regulation of capital and leverage in the financial industry. The guidelines don’t include any specific requirements yet, but they start off with a strong and obviously necessary principle: “Capital requirements for banking firms should be higher across the board.” One of the many problems evident during the economic crisis was that banks were extremely over-leveraged, and didn’t have enough money on hand to cover their losses when the downturn hit, pushing the government into facilitating mergers or bailouts.
Besides an across-the-board increase, the plan stipulates that firms that are designated Tier 1 (essentially those that are “too-big-to-fail”) have even higher capital requirements than everyone else:
Tier 1 FHCs should be subject to substantially heightened capital requirements. The failure or financial distress of a Tier 1 FHC can inflict serious damage on many other financial firms and the broader financial system. As a result, Tier 1 FHCs should be subject to higher capital requirements than other firms in order to force them to internalize the costs of such potential spillover effects. Capital requirements for Tier 1 FHCs should be strict enough to be effective under extremely stressful economic and financial conditions.
These are smart steps (many of which were suggested by Elizabeth Warren’s Congressional Oversight Panel back in January). In particular, hitting the “too-big-to-fail” firms with higher requirements is a no-brainer, as it will both mitigate some of their competitive advantages and potentially bring down overall banker compensation. Treasury’s outline also includes a strict constraint on leverage (the use of debt to supplement investment) and an increased emphasis on higher quality forms of capital, both of which make sense.
But the most interesting bit of the plan is the idea to consistently alter capital requirements — and even accounting standards — as the business cycle moves. This would help to reduce the typically pro-cyclical actions that banks take during an economic downturn. Current static capital requirements “encourage banking firms to contract lending or shed assets during a credit crunch,” which only exacerbates the downturn, leading to further cutting back by the banks in a vicious cycle. Treasury’s proposal would change that, imposing higher requirements during boom times and easing the requirements during a downturn:
Efforts to reduce the procyclicality of the regulatory capital regime, or even introduce countercyclicality, have great appeal from a macro-prudential perspective. Moreover, such policies also would contribute to the narrower micro-prudential goal of making individual banking firms less likely to fail. Capital regulation that cushions the effects of adverse system-wide shocks would better enable banking firms to absorb losses and continue operating as going concerns.
As Kevin Drum put it, “we won’t know how serious Geithner is about this stuff until he rolls out the details. But at least he seems to be singing the right songs.” Indeed, in terms of principles, this plan is a good start. Of course, “the industry is unlikely to accept new rules without a fight,” so it will be up to Treasury to turn a good vision into actual rulemaking, over the objections of the banks themselves.