What Jeb Hensarling Gets Wrong About Capital Requirements

Much of what’s in Hensarling’s speech is the general anti-Dodd-Frank platform that has been in circulation for several years: Get rid of the Volcker Rule, cut the independence of the Consumer Financial Protection Bureau, etc. But there’s a lot that goes further. Repeal the Chevron doctrine, subject the Federal Reserve’s prudential regulatory and financial supervision activities to appropriations, and so on. It “asks for the moon” in the words of American Banker.

One new agenda item requires some debate: Hensarling argues for a 10 percent leverage requirement that, if firms met it, would exempt them from all other Dodd-Frank capital requirements and heightened regulations. Reformers are unlikely to adopt this overall agenda—it’s pretty far out there—but in isolation, they could be interested in a deal that removes some capital requirements in exchange for higher leverage requirements.

I’ll put my cards on the table: Even in isolation, this is a bad trade. Leverage requirements should be higher, but a higher leverage requirement, by itself, can’t substitute for the rest of the Dodd-Frank capital requirements. First, it’s important to regulate the entire balance sheet, and each of the three parts of capital requirements amplifies and boosts the others. Second, the overall capital requirements prepare a firm for failure in a way that the static measure Hensarling describes would not. Especially if the resolution components of Dodd-Frank were gutted, capital requirements would need to do more, not less, to end Too Big to Fail.

Perhaps if the leverage requirement was significantly higher than what is proposed here it could work [1]. But perhaps not. I’m not sure on how it would play out as an option firms could choose; I’d need to see the specifics. But just at the high level, it’s a bad call.

Dodd-Frank Correctly Regulates the Entire Balance Sheet

Let’s have a simple graphic of a firm’s balance sheet:

There are three relevant Dodd-Frank capital requirements here. The first is leverage requirements, which set equity, or the balance between overall debt and overall assets a firm can have. The second is risk-weight requirements, which set the amount of debt a firm can have relative to a reasonable estimate of how risky those assets are. The third is regulating the composition of debt, which sets how much short-term versus long-term debt a firm should hold. As you can see, each of these requirements touches a different part of the balance sheet. What Hensarling proposes is to move to a system where we just focus on the first requirement, leverage, and ignore the others.

Why can’t we just have a higher leverage requirement replace everything? If we got rid of risk-weighted requirements, then firms could simply take on far more risk than they would otherwise, negating the safety rail that the leverage requirement put into place. As Dan Davies notes, leverage requirements miss whole categories of risk. A leverage requirement by itself gives firms an incentive to take on more risks by having a smaller balance sheet loaded with riskier assets. Risk-weighted requirements also require firms to document and understand the assets they have in a clear way, which necessitates due diligence.

Likewise, a higher leverage requirement won’t help if the debts of a financial firm are short-term and prone to panics. This is why Dodd-Frank regulates the distribution of debts. It makes it harder to rely so heavily on short-term debts by requiring that firms are able to make 30 days’ worth of payments (the liquidity coverage ratio, which Hensarling would remove), and regulators are currently working to ensure that firms have long-term debt to write down in case of a failure.

Leverage requirements are essential as well. They form a baseline of general stability for a firm. Crucially, if an asset class is rated incorrectly and suddenly downgraded, as AAA mortgage-backed securities were in the 2008 crisis, the leverage requirement becomes the binding constraint. It performs the last-line of defense in those cases of wide-scale incorrect valuations. It also pushes back against the cyclicality of risk-weighting, where risk-weighting can be weaker in a booming credit cycle, by providing a floor. But there’s no silver bullet here. Each of these three parts complements the others and addresses their strengths and weaknesses.

Other Parts of Dodd-Frank’s Capital Requirements are Essential to Ending Too Big to Fail

Beyond the three components already discussed, Dodd-Frank’s capital requirements check Too Big to Fail, and Hensarling’s plan has no answer for this. First, Hensarling’s plan doesn’t scale for larger and riskier firms, an essential part of capital requirements that Dodd-Frank does. See this graphic from Americans for Financial Reform:

A lot of other mechanisms are also missing. For instance, a firm that falls under Dodd-Frank’s capital requirements has limitations on bonuses, dividends, and stock buybacks, which forces it to rebuild its capital ratio. These and other requirements to take “prompt corrective action” (in the lingo) are essential foam on the runway in an effort to recover a weakening firm.

When asked what happens if a firm falls under his 10 percent, Hensarling said, “they will have 12 months within which to file a new capital plan […] to come back into compliance.” What’s to stop the firm from going in and out of compliance without real penalties? (Especially as Hensarling goes after regulators’ ability to demand compliance.) This hasn’t been thought out in the way Dodd-Frank has.

Dodd-Frank’s capital requirements also prepare a firm for failure. Being required to hold long-term debt gives either a bankruptcy judge or the FDIC room to work to write down the value of the firm. Not being able to pile into short-term debt helps check shadow-banking concerns. The last step of capital requirements, which is ensuring that firms have a sufficient level of capital to absorb losses, is currently being finalized, and is engineered around reasonable guesses of what is needed to end Too Big to Fail. There are stress tests to get a sense of how quickly a firm could fail, to better prepare for a crisis. Hensarling would get rid of all this.

Hensarling also wants to remove orderly liquidation authority, the so-called “death panel” for large banks. Instead, regulators would only have the option of bankruptcy in a crisis. “Bankruptcy, not bailouts” is the motto.

But if that were the case, it would mean you’d need even more, not less, preparatory work. The fight around living wills, currently ongoing, is all about whether or not firms are prepared to go through bankruptcy without causing undue damage to the greater economy. Regulators at the FDIC think firms are currently not, and they are using the living wills to ensure that firms structure themselves better and think through the process, which firms wouldn’t do otherwise. Hensarling would remove the living wills.

It’s a symptom of patriarchy that women’s pants are measured with one number; a more sensible solution is to have two numbers, for waist and inseam, like men get. And those are just pants. To regulate the risks of a trillion-dollar financial firm, you’ll need to go further than a single number.

[1] At 10 percent, as Joseph Lawler notes, this is below the much higher asks of 15 to 20 percent that have come from Brown-Vitter, Alan Greenspan, and others advocating for high capital requirements. Even at those levels, though, the issues of regulating the entire balance sheet and preparing a firm for failure are still relevant.