Should Smaller Banks Really Have Less Capital Protections?

Richard E. Farley is a partner in the leveraged finance group of the law firm of Paul Hastings. He is writing a book titled “The Crisis Not Wasted - The Creation of Modern Financial Regulation During F.D.R.’s First Five Hundred Days.”

Since the financial crisis in 2008, lawmakers have been promising an end to the “too big to fail” system of large banks. The latest move comes from Senators Sherrod Brown and David Vitter, whose proposal has the politically tinged title Terminating Bailouts for Taxpayer Fairness Act.

But nowhere in the proposal, however, is there a single comma that would end “too big to fail.” What the two senators are offering is an unprecedented attempt to unfairly advantage smaller “regional banks” and disadvantage bigger “megabanks.”

The pretext underlying the Brown-Vitter proposal is that smaller regional banks are less risky than the large institutions. Historically, however, just the opposite has been true. It was the smaller banks that failed in huge numbers during the Great Depression. And despite the urban legend of ruined Wall Street bankers jumping from windows, the New York banks had much more diversified loan and investment portfolios than the more rural, farm-loan-heavy smaller community banks and, frankly, the New York banks were more professionally managed.

During the savings and loan crisis of the late 1980s and early 1990s, it was again small banks - unchecked by national regulators - that caused the morass. The latest Brown-Vitter bill may again put us squarely in the same situation.

In many ways, the history of bank regulation in the United States has been a competition between the interests of the regional banks and those of large banks. The Glass-Steagall Act nearly failed in 1933 because big banks did not want to subsidize riskier small banks in a deposit insurance program. Senator Carter Glass, Democrat of Virginia, was ready to scuttle it because he thought insuring small banks might bankrupt the system. A compromise was reached allowing national banks to open branches everywhere that state banks could.

The crux of the proposed bill would require big banks to maintain a minimum common equity capital ratio of 15 percent of total assets, while only requiring 8 percent for regional banks. It would also exempt regional banks from all of the capital requirements of Basel III, the new regime of bank capital standards developed by banking regulators worldwide.

While the bill would also exempt big banks from Basel III, this would be of little significance as nearly all of the megabanks will voluntarily comply with the rules to maintain credibility within the international financial community.

The senators’ news release trotted out support from the usual “too big to fail” critics. But inexplicably, in their own release, Sheila C. Bair, a former chairwoman of the Federal Deposit Insurance Corporation and inexhaustible critic of big banks, did not support this aspect of the bill. She is quoted as saying that Basel III “was meant as a floor, not a ceiling, and proposals to strengthen bank capital requirements should build on that accord.”

The senators, however, dismiss Basel III as “too complex” - a system that would require a large bank “to conduct more than 200 million calculations in order to determine their regulatory capital under the Basel II framework, which Basel III builds upon.”

We learned in 2008 and again recently in the Cyprus collapse that world financial markets are deeply interconnected. While Basel III is far from perfect and will unquestionably need to be modified and updated over time and with experience, it is our best hope for a desperately needed uniformity of capital regulation standards. It would be foolhardy to scrap this.

Mr. Vitter and Mr. Brown acknowledge that their bill would set the capital bar for regional banks even lower than current market practices, including by lowering leverage capital ratios to 8 percent from 10 percent of assets. Yet this would increase, rather than decrease, the risk of bank failures.

The bill also contains a number of other benefits for community banks. It would expand the definition of “rural” lenders that could offer balloon mortgages; reduce some impediments for small banks and thrifts to raise capital or pay dividends; create an independent bank examiner ombudsman that institutions could appeal to if they felt they had been treated unfairly by their examiner; and adopt privacy notice simplification legislation.

There are certainly policy considerations that might justify favoring smaller banks over larger ones. Historically, these have included keeping capital in local hands, favoring agrarian lending to industrial lending and avoiding concentration of power in urban elites.

Prohibition against branch banking by national banks for most of American history is an example of a law in furtherance of these policies. Those laws have for the most part been scrapped because they fostered inefficient uses of capital and, in many cases, bad management. But at least they were honest about what they were trying to do.

Senator Brown, Democrat of Ohio, and Senator Vitter, Republican of Louisiana, have promoted the bipartisan nature of their proposal. But in the end, the bill attempts to mask favoritism of regional banks over larger banks in “no more bailouts” rhetoric, when nothing in the proposal would prevent the future bailout of a single bank. The only thing this effort may accomplish is creating an uptick in contributions to the senators’ re-election campaigns from regional banking interests.