Too Big To Fail, Part IV: Capital Requirements

And my trudging through the new Financial Stability Improvement Act of 2009 draft (.pdf) continues. So far today, I've covered the Council, how it identifies risky firms and the kind of heightened regulatory requirements those firms can expect. Next up: capital requirements. Although it offers up few specific quantitative details (that will be left to the Federal Reserve), the document has a lot to say about this subject.

The proposal distinguishes between four capital categories that a firm can belong in:

- Well Capitalized (you're good)
- Undercapitalized (you need capital)
- Significantly Undercapitalized (you really need capital)
- Critically Undercapitalized (you're screwed)

The Fed gives firms one of these four labels based on several measures including:

- Leverage limits
- Risk-based capital requirements
- Whatever else the Fed sees relevant

As I mentioned in the last post, the details are sketchy, but the Fed will decide what capital levels will put firms into each of the four buckets. (I noted one quantitative leverage measure in a note at the end of my last post.)

So what happens if a firm is anything other than "well capitalized"? It depends how badly undercapitalized the firm is. Any firm in the lower three buckets must:

- Not distribute capital to shareholders
- Be closely monitored by the Fed
- Form a "realistic" capital restoration plan
- Not grow assets further until well capitalized
- Not engage in new lines of business (unless the Fed approves)

I find all of this relatively straightforward. The part restricting asset growth might seem odd, but I think the idea is that those firms should focus on growing capital before they grow other assets. Moreover, the Fed would likely welcome new lines of business if they legitimately contributed to capital growth. So I don't see any of these requirements as particularly restrictive.

For "significantly" and "critically" undercapitalized firms who fail to implement capital restoration plans, there are some additional actions the Fed might take:

- Force equity sales
- Force acquisition by or merger with another firm
- Restrict transactions with affiliates
- Further restrict asset growth
- Restrict certain risky business activities
- Order a new board of directors elected
- Dismiss senior officers
- Force divestitures
- Restrict the compensation of senior officers
- And for some critically undercapitalized firms, the Fed may even force bankruptcy -- after 90 days of being critically undercapitalized.

Now we're talking. As you can see, you don't want to be a firm in one of those two categories. This legislation definitely takes the gloves off when dealing with severely undercapitalized firms who don't implement capital restoration plans. The compensation restraints are particularly noteworthy, as they would forbid a bonus or raise to any senior executive officer. Many of these requirements are unchartered regulatory territory.

The involuntary bankruptcy option appears to foreshadow a non-bank resolution authority. It does (spoiler: it's the FDIC). In a subsequent post I will address this aspect more thoroughly, but this section of the document clearly sets the stage.