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Choice 2.0, Title VI vs. The Hoenig Proposal
The release of Financial Choice Act (FCA) 2.0 means now we have two broad policy options concerning bank capital requirements that bear…
The release of Financial Choice Act (FCA) 2.0 means now we have two broad policy options concerning bank capital requirements that bear some resemblance. Over the last two years, the House Financial Services Committee, under the leadership of Representative Jeb Hensarling has worked to find a replacement for the 2010 Dodd Frank Act. FCA 2.0, Title VI offers regulatory relief in exchange for higher regulatory capital requirements. Meanwhile, Federal Deposit Insurance Corporation Vice Chairman Thomas Hoenig has been thinking along the similar lines.
In a recent speech, he too suggested a way to offer banks regulatory relief in exchange for higher regulatory capital requirements. The proposal follows up on a 2015 speech in which he suggested that community banks had been voicing their complaints against frequent bank examinations, the compliance burden associated with consumer finance regulation, risk-based capital rules, and the overall growing complexity of the call report.
Indeed, the call report for bank holding companies in June 1996 was 29 pages long (the instructions were 239 pages long), while the March 2017 call report is now 65 pages long (the instructions are now 598 pages long). For comparison, the most recent call report for credit unions is 28 pages long (and the instructions are 106 pages long), and they’re longer than they used to be. Staff at the Federal Reserve Bank of Minneapolis, as well as my colleagues have pointed out that banks may also face higher compliance costs, which affects their performance and ability to serve customers. So let’s go through the options.
FCA 2.0, Title VI
As described in section 601, the FCA allows bank holding companies and subsidiaries to simultaneously choose a regulatory off-ramp if the holding company has an average leverage ratio, meaning equity-to-total consolidated assets, of at least 10 percent. The leverage ratio equals the average over the last four quarters. The “election” to take the off-ramp would take place 30 days after Federal Reserve receives notification of the choice.
Section 602 lists the benefits of the choice as exemptions from federal laws, rules or regulations concerning capital and liquidity, the distribution of dividends to shareholders, supposed systemic risks or concerns about concentration risks following mergers and acquisitions.
Section 605 (12)(iii) allows banks with less than $15 billion in total assets prior to passage of Dodd-Frank to include Trust Preferred Securities (TPS) originated prior to Dodd-Frank, as part of capital. Keep in mind, however, that a recent study showed that during the run up to the crisis, banks used TPS to engage in regulatory arbitrage, and to increase risk-taking; and it was not unique to large banks but rather low-franchise value (less profitable) banks that sought to benefit from risk-taking.
Also, keep in mind that I can imagine a scenario in which smaller holding companies will elect to choose the higher leverage ratio option, since they may already be operating there, while larger holding companies will not. After all, to the extent that Dodd-Frank regulations create barriers to entry, the added regulatory burden serves to protect incumbent firms, especially larger firms, which can better manage the associated compliance costs.
The Hoenig Proposal
Regulation for Traditional Banking Activities
Vice Chairman Hoenig has offered a two part proposal. For banking entities that only engage in traditional banking activities (TBA), Hoenig proposed that they be given regulatory relief if they had: 1) at least 10% equity to assets, 2) no trading assets or liabilities, 3) derivative positions (excluding interest rate swaps and foreign exchange derivatives), and 4) less than $8 billion in total cleared and non-cleared notional derivatives exposures. Relief would come primarily from not having to: undergo Dodd-Frank stress testing as per section 165(i)(2), satisfy Basel capital requirements, fill out call report schedules for derivatives, regulatory capital requirements, and trading assets and liabilities. They could then move to an 18 month, rather than a 12 month, examination cycle. They would also get some regulatory relief from the regulatory burden associated with fair lending violations and appraisal requirements.
Regulation for Non-Traditional Banking Activities
For banks that do not satisfy the criteria described above, Vice Chairman Hoenig has recently proposed separating banking activity into TBA and non-traditional banking activities (NTBA). A financial holding company (FHC) would then include traditional banking activities (TBA) that would be conducted by a bank intermediate holding company (BIHC), and nontraditional banking activities (NTBA) that would be conducted by a nontraditional intermediate holding company (NIHC). Insured depository institutions would be placed under the BIHC. Broker dealers, futures commission merchants, swap activities and all other non-traditional banking activities, including Edge Act and Agreement Corporations and their subsidiaries would be placed under the NIHC.
Perhaps the thinking here is that holding companies have become unwieldy. After all, our increasing reliance on them has coincided with the decline in market discipline and the increasing duration and costs of banking crises in the U.S.
Some interesting features of the proposal include the fact that a 10 percent equity-to-asset leverage ratio would be required at: 1) the FHC, similar to FCA 2.0, but also 2) at the BIHC and all insured depository institution subsidiaries, and 3) at the NIHC. Moreover, the FHC would issue common equity shares, while the NIHC would issue so-called tracking shares, which would also be traded. The holding company would issue such shares, but their price could reflect the performance of the subsidiary. While the proposal does not call for the BIHC to issue tracking shares, it might be possible to do so, which could solve a potential problem that may arise under Dodd-Frank’s Orderly Liquidation Authority (OLA).
American Enterprise Institute scholar Paul Kupiec has observed that while holding company shares trade, banking subsidiary shares usually do not, which poses a challenge in terms of establishing adequate capital for a banking subsidiary. Ever since the Federal Reserve’s revision in 1984 of Regulation Y, the holding company has been viewed by some as a “source of strength,” which implies that the holding company would infuse capital into a failing subsidiary. OLA implicitly appeals to the “source of strength” doctrine. While it’s not clear if bank holding companies would actually do this, regulators are now counting on it. Paul Kupiec’s solution is for holding companies to issue debt as capital for the banking subsidiary, since the banking subsidiary shares currently do not trade, but perhaps the issuance of subsidiary tracking shares could serve this purpose, too.
It would be easy to blame regulators for the current state of complex U.S. regulatory capital requirements, and therefore conclude that the Congress should take action. However, this would overlook the fact that it was the Congress that asked regulators in 1983 to come up with a multilateral way to get U.S. banks to increase their capital in a way that would not “harm” U.S. banks relative to their competitors, which culminated in the 1988 Basel Accords. Rather than assign blame, going forward if the aim is to protect taxpayers from bearing the costs of future crises, simpler, higher capital requirements at the banking subsidiary level can serve that purpose.