Taming the Unruly Bulls

With regulatory measures falling flat, Congress is taking the lead on ending too-big-to-fail, advancing legislative action to subdue Wall Street’s financial mega-institutions once and for all

By Kelly Pike and Tim Cook

Fed up with years of Wall Street’s perilous blundering and reckless shenanigans, increasingly impatient Washington policymakers are on tenterhooks to end too-big-to-fail once and for all. From JPMorgan Chase’s billions in risky trading losses from the so-called London Whale debacle to Ben Bernanke’s admission that “too-big-to-fail is not solved and gone,” debate over ending too-big-to-fail has not only rekindled, it’s on pace to become a full-fledged bonfire on Capitol Hill.

Most recently, that debate—as demonstrated by legislation introduced by Sens. Sherrod Brown (D-Ohio) and David Vitter (R-La.) in April to sweep away megabanks’ marketing and government subsidies—has moved rapidly from the abstract to bipartisan discussions over real-world policy solutions that would truly address Wall Street’s systemically risky institutions. “We are beginning to see not only regulators in very high places but also key members of Congress saying, ‘This isn’t moving fast enough, we need to do something legislatively,” says Terry Jorde, ICBA senior executive vice president and chief of staff. “We need to be moving forward. This is a big risk to our country, and we can’t repeat the mistakes of our past.”

Failing to take further policy action to address too-big-to-fail would only perpetuate the current, serious risk those giant institutions pose to the financial system, agrees Arthur E. Wilmarth Jr., a professor at the George Washington University Law School who worked as a consultant to the Financial Crisis Inquiry Commission, the body established by Congress to report on the causes of the financial crisis.

Wilmarth says more lawmakers are recognizing that—five years after the Wall Street financial crisis—regulators will never be able to fully control megabanks or prevent another financial crisis. “Most people think there are no bullets left to fight the next war,” he says. “We’re borrowed to the hilt and the Fed is quantitative easing out the wazoo. What can the Fed or Treasury do to contain the next crisis?”

“These [too-big-to-fail] companies ought to compete, to succeed and fail, based on their own actions, when we have a relatively even playing field in our financial sector,” MIT professor Simon Johnson wrote last month in The New York Times. His article, titled “The Case for Megabanks Fails,” offers a meticulous response to megabank lobbying distortions: “We had this [framework] for a long time and it worked well. Small banks are willing and able to step up again, once we remove the excessive subsidies from their too-big-to-fail competitors.”

Fortunately, almost every day another regulator and lawmaker in Washington publicly admits that the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 has not resolved, and will never by itself fully resolve, the too-big-to-fail threat that financial institutions still pose to the nation’s economy and financial system. As a result, members of Congress are closely following and increasingly joining the growing debate to enact legislation. The approach of forcing megabanks to restructure their activities or give up their government subsidies—actions that would move far beyond the systemic-risk controls adopted in the Dodd-Frank Act—is increasingly accepted as the decisive, necessary next step that Congress should require.

Even Wall Street financial lobbyists like Tim Pawlenty, chief executive of the Financial Services Roundtable, concede that too-big-to-fail is a problem that must be resolved. “Institutions that perform poorly and do bad things should fail; they shouldn’t be subsidized and they shouldn’t be immune from prosecution,” Pawlenty offered during a recent industry forum hosted by the American Banker newspaper.

How to rein in the megabanks and giant nonbanks—through such proposals like the Brown-Vitter capital legislation—has become the central question within the growing debate across Capitol Hill. Frameworks for downsizing or restructuring the largest banks are receiving close attention from key lawmakers, including the Senate Banking Committee and the House Financial Services Committee. Both committees have held hearings addressing too-big-to-fail.

In April, a House Financial Services subcommittee held a hearing reviewing the existing regulatory powers available to force megabanks to divest their assets or nonbank affiliated operations. That same month nearly 1,000 community bankers attending the Washington Policy Summit from around the country underscored the need for additional too-big-to-fail legislation during meetings with members of their congressional delegations.

ICBA Chairman Bill Loving, president and CEO of Pendleton Community Bank in Franklin, W.Va., reinforced the message the community bankers delivered in an op-ed piece published in American Banker shortly before the Washington Policy Summit. “For community bankers, the answer to the ‘too big to fail’ crisis is not more regulation,” Loving wrote. “Only by actually downsizing and restructuring ‘too big to fail’ institutions—by limiting the systemic risk created by the sheer size and interconnectedness of the institutions that put our financial institutions and economy at risk—can we eliminate unfair competitive advantages, unleash our free markets and allow community banks to compete in the financial landscape.”

A major jump-start

The Brown-Vitter legislation, the Terminating Bailouts for Taxpayer Fairness Act of 2013 (TBTF Act, S. 798), is widely considered a game-changing catalyst in the too-big-to-fail debate in Washington. Aimed at ending the heavy federal subsidies and distorted market funding advantages of Wall Street’s financial mega-institutions, the legislation would impose a minimum 15 percent leveraged equity capital standard on the largest banks and an 8 percent minimum standard on midsize and regional banks. (Community bank capital standards would remain at current levels.)

Forcing regulators to abandon the current, more risk-based capital approach of the Basel III accord, the Brown-Vitter bill would require megabanks to focus on strengthening their common equity capital and “other pure, loss-absorbing forms of capital.” Under the bill’s framework, regulators could only use risk-based capital requirements as a supplementary consideration in determining allowable capital ratios for firms with more than $20 billion of assets. The banking agencies would also be directed to count off-balance-sheet assets and obligations as well as factor in counterparty credit risk in calculating derivatives exposures.

As Brown and Vitter wrote jointly in a New York Times article summing up their legislation’s objectives, “Requiring the largest banks to finance themselves with more equity and with less debt will provide them with a simple choice: They can either ensure they weather the next crisis without a bailout, or they can become smaller.”

“The goal is simple,” Vitter later added. “The goal is to even that playing field, to not have size [be] an inordinate factor … and the goal is to create a cushion against disasters and a cushion for taxpayers.”

Or as ICBA President and CEO Camden Fine explained in a message to community bankers, “Capitalism is about capital, not taxpayer subsidies.”

Aiming to comprehensively tackle megabank government subsidies, the Brown-Vitter bill would also prohibit non-depositories from accessing the safety nets of the Federal Reserve’s discount window or FDIC deposit insurance. The bill would also restrict the ability of bank holding companies to move their assets or liabilities from nonbanking affiliates to a banking affiliate, a provision designed to wall off a commercial bank’s activities from its nonbank activities.

In addition to bringing market discipline to the too-big-to-fail banks, the Brown-Vitter bill also offers much-needed regulatory relief to community banks that will allow them to serve consumers and small businesses in their areas. (For more, read Washington Watch on page 74.)

The Brown-Vitter bill, thanks to its serious-minded substance and detail as well as its bipartisan start, has made a big splash in Washington. The quick and vocal backing by ICBA and community bankers—despite all the other national banking trade associations failing to support the legislation—has also given the legislation immediate credibility and momentum.

“There are obviously interests working overtime against us,” Vitter noted. “But I think clearly there’s been building momentum for this approach over the last year.”

Major regulator proposals

Further underscoring the limitations of today’s systemic-risk regulatory framework, two prominent and detailed policy roadmaps have been proposed by regulators themselves, not lawmakers. One legislative proposal has been prepared by Thomas Hoenig, former head of the Federal Reserve Bank of Kansas City and current FDIC vice chairman. Another prominent legislative plan has been outlined by Richard Fisher, president of the Federal Reserve Bank of Dallas.

A knowledgeable champion of community banking issues for decades, Hoenig has been an outspoken but formidably authoritative critic of the government’s policy actions so far to resolve too-big-to-fail. Before arriving at the FDIC last year, Hoenig outlined a detailed legislative plan that would re-establish the statutory walls that once separated core banking activities from speculative financial functions—including the activities that heavily contributed to the most recent financial crisis.

“There are really two aspects to the Hoenig plan,” says Karen Thomas, ICBA senior executive vice president, government relations and public policy. “There’s the goal of reducing systemic risk so that if a bank gets into trouble it won’t destabilize the system or economy. There’s also the goal of removing the perception that too-big-to-fail exists to blunt its impact on competition.”

The fundamental objective of the Hoenig plan would be to separate among institutions operating under different charters risky investment activities from conservative core banking activities. Under the plan, deposit insurance and access to the Federal Reserve’s discount window would be available to entities, including community banks, that engage only in core deposit taking and lending activities. Core banking institutions would continue to be permitted to provide fee-based services such as underwriting securities; advisory services; and trust, asset and wealth management services that do not put the bank’s capital at risk.

However, the Hoenig plan would prohibit core banking institutions from engaging in the far-ranging investment securities dealing, market making and proprietary trading activities currently pursued by today’s Wall Street financial institutions. Only separately chartered institutions would permit those investment activities. Customer trading would be prohibited—eliminating the temptation to “game the system” by disguising proprietary trading as customer trading. In turn, core banking institutions would also be prohibited from holding “complicated” securities, such as multilayer structure securities (including the volatile collateralized debt obligations that helped fuel the mortgage market’s most recent boom and disastrous bust).

To rein in Wall Street’s shadow banking industry, the plan would reform the use of money market funds and short-term repurchase agreements (the so-called repo market) to ensure the safety net can’t be used to bail out those activities. Money market mutual funds would be required to have floating net asset values, and the bankruptcy laws would be changed to eliminate mortgage-related assets from the automatic stay exemption when a borrower defaults on its repurchase obligation. These restrictions would remove a short-term funding subsidy that encourages risky behavior.

Thomas says ICBA supports the major thrust of the Hoenig plan because it would align the interests of core banking institutions and their customers. Unlike engaging in trading and investment activities, which can set up a conflict of interest between a bank and its customers, the core depository banks only would be rewarded for engaging in activities that are essential for a well-functioning economy. Not only would the proposal reduce risk among large financial institutions and shadow banks, it would take away their too-big-to-fail funding advantage—estimated by Bloomberg to be 80 basis points—over community banks and other institutions.

Unlike the Hoenig plan, which would remove risky activities from banking altogether, the legislative reform plan proposed by Fisher would downsize big banks into multiple but smaller business entities. Those smaller institutions would have an entity involved in “basic, traditional commercial banking” and the rest would be de facto shadow banking affiliates. Under Fisher’s plan, only the commercial bank and its customers would have access to deposit insurance and the Fed’s discount window. Shadow banking affiliates and the holding company would have no taxpayer support.

While theoretically this separation of financial activities is the way the banking world should function now, it clearly doesn’t. To fix this, the Fisher plan would remove today’s implicit guarantee through disclosures. “Every customer, creditor and counterparty of every shadow banking affiliate and of the senior holding company” would have to sign a disclosure acknowledging that the entity they are dealing with has no federal safety net.

Finally, the Fisher plan calls for the largest financial institutions to be restructured so that each entity could speedily go through the bankruptcy process if needed. Calling this “too small to save,” the plan leaves the restructuring to bank management and boards of directors to ensure the spinoffs are viable and profitable. Few details are offered on how to do this, with Fisher remarking that it “should be accomplished with minimal statutory modifications and limited government intervention.”

While Fisher has not specifically outlined a size cap for large banks, the January speech in which he first outlines his plan calls out the 12 largest megabanks, each with $250 billion or more in assets.

So far no legislative version of either Hoenig’s or Fisher’s plan has been introduced in Congress, but their plans have been part of the growing debate on Capitol Hill.

Ahead from here

The challenge ahead for community bankers is turning a growing bipartisan consensus into concrete action in Congress.

Sen. Bernie Sanders (I-Vt.) and Rep. Brad Sherman (D-Calif.) have also introduced legislation that would require too-big-to-fail financial firms to be broken up, contributing to the growing momentum on Capitol Hill for addressing these institutions’ systemic risks. The Sanders-Sherman bill would give the Treasury Department 90 days to identify any institution, including commercial banks, investment banks, hedge funds and insurance companies, whose failure would have a catastrophic effect on the stability of either the financial system or the U.S. economy without substantial government assistance. Treasury would also then be required to break up those institutions within a year after the bill’s enactment.

Moreover, several key members of Congress, including Sen. Elizabeth Warren (D-Mass.) and Rep. Carl Levin (D-Mich.), are expected to continue to push Congress to pass new too-big-to-fail legislation. Among the House and Senate banking committees, the most vocal has been House Financial Services Chairman Jeb Hensarling (R-Texas), who has allowed a series of subcommittee hearings on the need to end too-big-to-fail. Speaking to community bankers at ICBA’s Washington Policy Summit, Hensarling again recognized how too-big-to-fail has “metastasized” as the largest banks and community banks have consolidated. He advocated right-sizing the largest financial firms by reducing moral hazards and supporting a level playing field.

Yet, when Hensarling talks about ending too-big-to-fail, he’s often not just talking about megabanks, says Brian Cooney, ICBA’s senior vice president of congressional relations. The chairman is also sometimes including big, government-controlled entities like Fannie Mae and Freddie Mac, which also required government bailouts, and the Federal Housing Administration, which may need a bailout in the future.

While addressing these housing agencies is an important step in setting the future of national housing finance policy, one potential big hurdle is that the complex and potentially divisive issue of federal housing policy reform could divert Congress’s attention from addressing too-big-to-fail.

Perhaps surprisingly, while the Obama administration will be closely but cautiously watching the congressional debate over too-big-to-fail, it isn’t likely to goad the discussion. Because the administration has invested political capital already into enacting the Dodd-Frank Act, it doesn’t appear to relish addressing the issue again quite so soon. Regardless, the administration will continue to closely follow the public’s reaction to the ongoing debate, as will the Congress.

In that regard, one fear is that much of the public anger that resulted from the Wall Street financial crisis and the megabank bailouts could fade with an improving economy, some policy analysts say. “Some people think we’re facing a situation where not a lot will happen until another disaster or crisis,” Wilmarth says.

So far, however, the public’s collective memory remains vivid and its ire keen over how Wall Street’s megabanks contributed to the financial crisis. A recent, widely reported survey by Rasmussen Reports found that half of all Americans favor breaking up the 12 largest megabanks, with only 23 percent opposed. More than half said the government should let too-big-to-fail banks go out of business if they can no longer meet their financial obligations.

“This tells me one thing: The American public is getting fed up,” Fine wrote in his blog, Finer Points, in response to the survey. “Now it appears the average Joe and Joanne have had their fair share of it too—and they are just as sick of it as their community banker down the street is.”

But even if little appears to be accomplished legislatively on too-big-to-fail this year, the fact that so many legislators are having serious discussions about too-big-to-fail is creating momentum on which ICBA and community bankers will continue to build. “It’s a conversation that’s going on in the op-eds, in the press and in speeches various policymakers have given,” says Thomas. “You need to have a lot of robust conversation before you can get to the point of something being done.”

Unforeseen events could easily play a major role in driving too-big-to-fail as a legislative priority for Congress, Cooney points out. “One more major scandal by any of the big banks could create a tipping point that propels this issue into a huge legislative priority for Congress,” he says.

Certainly, ICBA will move aggressively to ensure today’s discussions continue on Capitol Hill until the financial system is once again safe, stable and competitive—liberated from the dangers of too-big-to-fail. As Loving wrote in his widely distributed op-ed, “For community bankers like me who want our industry to survive and thrive, we must stand together as one to break up the ‘too big to fail’ stranglehold and ensure a future for Main Street community banking and the communities we are privileged to serve.”

Kelly Pike, a freelance writer in Annandale, Va., is a former staff writer and editor for ICBA Independent Banker. Tim Cook is ICBA’s senior vice president of publications.