Conservatives who are working to undo Obama-era Wall Street reforms do have one regulation they’d like to keep in place: high capital requirements for financial institutions, so that big banks can pay for their own losses if they run into trouble instead of needing a government bailout. The House Republicans’ Financial CHOICE Act follows this model, gutting scores of rules created by the 2010 Dodd-Frank law in favor of a simple capital buffer.
That legislation, which passed the House along party lines but is not expected to pass the Senate, would be a disaster: Its buffer is too low, and there’s no mechanism to enforce it. But conservatives have been interested for years in regulating capital. Democratic Senator Sherrod Brown carried bipartisan legislation through two Congresses calling for higher capital requirements. Conservative economists, central bankers and academics all share this view.
But Randal Quarles, the most important regulatory official at the Federal Reserve, announced last week that reducing capital requirements is a top priority—and Fed Chair nominee Jerome Powell supports the idea. So Donald Trump’s two biggest appointments to the central bank not only agree on dismantling the relatively more stringent regulatory apparatus in place since the Great Recession, but are taking the one policy conservatives have long supported in financial regulation and targeting it for degradation.
Capital refers to how much money a bank can borrow to fund its operations. The simplest measure of capital, known as leverage, looks only at how much equity banks carry compared to total assets like loans. According to a September 2016 FDIC report, the average big bank had a leverage ratio of 5.6 percent, meaning it had $5.60 in capital for every $100 it lent out. Another measure of capital known as the Tier 1 ratio is risk-weighted, meaning that the assets are counted differently according to the risk they hold. This can prove disastrous if the “low-risk” assets are actually dangerous—as mortgage-backed securities were considered to be during the housing bubble.
Banks don’t want high capital levels because financing operations through borrowing, rather than with their own money, creates more profit. For example, if a bank makes a $100 investment and borrows $80, and the investment goes up 10 percent, they’ve made $10 while risking $20 of their own money, a 50 percent gain. But if they borrowed $95 for that investment, they make $10 while risking only $5, a 200 percent gain. Scale that up and you can see how borrowing is much more lucrative.
Bank capital standards are set internationally, per a global agreement known as Basel III. But under Daniel Tarullo, who ran bank regulatory policy at the Fed during the Obama administration, the United States set limits higher for leverage and Tier 1 capital, particularly for the largest financial institutions. Holding more capital makes the biggest financial institutions less profitable but also more stable.
Quarles, Trump’s choice to direct bank regulation at the Fed, took over in October, and on Friday he gave one of his first speeches outlining his plans. “I am not advocating an enervation of the regulatory capital regime,” Quarles insisted, but went on to recommend precisely that. The two key areas marked for change include a “simplification” of capital rules for smaller banks, and a “recalibration” of the leverage ratio for all firms. Bloomberg reports that Fed staffers are already rewriting the leverage rule, “a move that could free up billions of dollars for some Wall Street giants.” Quarles promised a formal proposal on leverage “relatively soon.”
This shift would mean abandoning America’s post–financial crisis strategy of going beyond the Basel III framework in its regulation of leverage and capital. European banks have significantly lower requirements, and Powell, who is awaiting confirmation as Fed chairman, said in June that lowering leverage “could help to reduce the cost that the largest banks face.”
Reducing leverage increases risk almost by definition. Thin capital ratios turned a drop in profitability in 2008 into a massive credit crisis. But it’s the severe break with high-level conservative thinking on the topic, in favor of a big gift to the banking sector, that’s startling here. As recently as a couple of months ago, committed conservatives would trade practically the entire regulatory regime for higher capital requirements. Now the conservatives in power, already busily neglecting regulatory enforcement, want to send those capital levels lower.
One problem for Quarles is that the Fed needs partners at other banking regulators to change capital rules, and some old-school conservatives lurk there. That’s particularly true at the FDIC. Thomas Hoenig, the Republican vice-chair, is the most committed conservative regulator on capital requirements. Last March, he proposed a 10 percent leverage ratio, which is far higher than current law. And in a letter in August, he argued against degrading capital requirements. He noted that if JPMorgan Chase held onto its earnings rather than paying them out to shareholders through dividends, it could issue hundreds of billions of dollars in additional loans, which benefits the broader economy.
Hoenig may eventually get outvoted on the FDIC, but he’s experienced in intra-regulator fights. A Republican split on bank rules could highlight how letting banks enrich shareholders and executives puts us all at greater risk of another crash. If conservatives abandon strict capital requirements, there’s really no major regulation left to impose on the banks. The result could be combustible.