Most banks would still make good money under a tough new piece of financial overhaul legislation introduced in the Senate last week.
Senator Sherrod Brown, Democrat of Ohio, and Senator David Vitter, Republican of Louisiana, have written a bill that would substantially strengthen the financial foundations of most banks.
The legislation focuses on capital, the part of a bank’s balance sheet that acts as a buffer to absorb potential losses. Under the bill, banks with more than $500 billion in assets would have to hold capital that is equivalent to at least 15 percent of their assets. That’s far higher than the capital levels required today. But only six institutions, the nation’s megabanks, have more than $500 billion of assets.
Most other banks, many of them still quite big, would get to hold capital that is equivalent to 8 percent of their assets.
Many critics of the Brown-Vitter bill have said the proposed capital requirements are recklessly high. They contend that banks won’t be able to make a sufficient return on their capital. This would prompt them to curtail the unprofitable lending, depriving the wider economy of credit, according to the critics.
What do the numbers say?
A good starting point is to look at the profits that banks are earning on their assets. In 2012, bank earnings were equivalent to 0.75 percent to 0.8 percent of their assets, according to data from SNL Financial.
At a bank with $100 billion in assets, the 0.8 percent return on assets translates into earnings of $800 million a year. Under Brown-Vitter, the bank would have an 8 percent capital requirement, requiring it to hold capital of $8 billion.
The question then becomes: How much can that bank earn on that capital? Shareholders will want bank executives to try and maximize that measure of profitability, called return on equity (capital is composed of equity).
How does our $100 billion bank do? Pretty well, in fact. With capital of 8 percent, its $800 million of profits translates into a return on equity of 10 percent. Bank analysts estimate that the bank has to effectively “pay†10 percent to 12 percent for its capital. So, this bank would just about cover its cost of capital.
But banks may earn far more than that in coming years. Currently, their return on assets is still somewhat depressed. Profits are likely to balloon if the housing market revives and the economy grows at higher rates. Look at what happens if the assets of our $100 billion bank show a return of 1.2 percent, a rate that was commonly achieved in better times and is already being exceeded by some banks now. That would translate into an impressive 15 percent return on equity.
But what about the six largest banks that would have to hold 15 percent capital? They would find it much harder to achieve strong returns on that much higher level of equity. As a result, they would have a big incentive to reduce their size below $500 billion to qualify for the lower 8 percent capital threshold. That could mean spinning off business. That would be disruptive, but shareholders might soon see the advantages of more streamlined banks and flock to those that focus on strengths.
Taxpayers would breathe more easily as banks downsize. When megabanks fail, the authorities feel they have to bail them out to protect the wider financial system. And it’s clear that Brown-Vitter would likely shrink the ranks of such lenders.
The Brown-Vitter bill may get nowhere. But the bill has already served a useful purpose. These numbers, based on the text of the legislation, show how a simple change to capital regulations could do much to protect the country from the too-big-to-fail threat while allowing the vast majority of banks to earn reasonable returns as they lend to consumers and companies.
The big risk would lie in shrinking the six largest financial companies. It would be no easy process to take Bank of America and JPMorgan from more than $2 trillion in assets to $500 billion. It would likely weigh on credit creation and confidence, even if it were done over an extended period.
In essence, then, Brown-Vitter forces us to ask whether that downsizing risk is preferable to the risk of living with too-big-too-fail banks for the foreseeable future.
