Is Congress' Financial Reform Too Soft on Bank Capital?

Do the House's and Senate's bills both fail to take into account one of the most central problems of the financial crisis?

One of the big problems during the financial crisis was that banks didn't have adequate capital bases. As a result, losses threatened their existence when credit dried up. So it seems righting this wrong would be an obvious goal of new financial regulation. A Bloomberg article today claims that this significant issue has been overlooked, as the two bills floating around Congress fail to call for specific changes in capital requirements. Is the legislation too weak in this regard? I don't think so.

Here's how the article begins:

In 2,615 pages of financial reform legislation introduced in the U.S. Congress, there are no rules to ensure that banks keep enough cash-like assets when credit disappears.

What the Bills Say

I don't think this is a fair assessment of the reform proposals out there. It's sort of true that neither bill has a specific number listed as a new capital requirement banks will face. But that's because it isn't really Congress' role to set this standard. In fact, capital requirements should be set by regulators and must be done globally, to ensure competitiveness.

Both proposals do, however, say that the new systemic risk councils will set heightened capital requirements for big financial institutions. Here are the bills explaining the roles of their new systemic risk regulators. First, the House bill (.pdf):

The stricter standards imposed by the Board under this section shall include--
(i) risk-based capital requirements and leverage limits, . . .

The Senate version (.pdf):

The recommendations of the Council under subsection (a) may include--
(A) risk-based capital requirements; . . .

This make sense. Once you have a regulator with a strong understanding of macroeconomic risk, it can put in place appropriate capital requirements. I should also note that the House bill goes even further, slapping a 15 to 1 leverage limit ceiling on these firms. Even though that's not technically a capital requirement, it will serve to ensure that these firms keep their borrowing within reason, unlike they had prior to the financial crisis.

Resolution Fund

I actually think there's an even more important factor to consider, however. These bills would both create a new resolution authority, which would control a big fund (paid for by big banks) to cover the costs of winding down large institutions that fail. So long as banks can fail, capital requirements become less of a political concern. Beyond protecting taxpayers from losses, it's really the job of management and shareholders to make sure banks have enough capital to withstand a severe credit crunch. If a bank can't, then it will fail. As long as its equity and debt holders are the only ones to suffer in that scenario, the government probably shouldn't be too concerned how much capital it had leading up to its failure.

So these bills do contain explicit language which will lead to stricter capital requirements for large financial institutions. But more importantly, they seek to make the failure of any firm possible without a catastrophic shock to the broader economy. While I too would have liked to have seen regulators act more quickly to set higher global capital requirements, given the fragile state of banking, new requirements will have to be slowly phased in.