Can These Legislators Kill ‘Too Big Too Fail’?

Too Big To Fail“Progressives and conservatives can debate the proper role of government, but this is one principle on which we can all agree,” begins a New York Times article written by Senator Sherrod Brown (D-OH) and Senator David Vitter (D-LA). “The government shouldn’t pick economic winners or losers.”

The problem, the senators go on to point out, is that during the 2008 financial crisis, the government did just that.

The debate about whether or not the government had a choice to bail out major financial institutions that were deemed ‘too big to fail’ (really, too interconnected) will probably continue indefinitely. Thankfully, the legislators don’t seem interested in lingering on the past. Instead, they seem keen on pursuing the idea that, with a new understanding of economic crises in hand, the United States should pass legislation that would prevent a bailout situation from ever happening again.

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“On Wednesday,” they write, “we will introduce legislation to ensure that all banks have proper capital reserves to back up their sometimes risky practices — so that taxpayers don’t have to. We would require the largest banks to have the most equity, as they should.”

“Our bill aims to end the corporate welfare enjoyed by Wall Street banks, by setting reasonable capital standards that would vary depending on the size and complexity of the institution”…

How did we get here?

The Federal Reserve was established in 1913 to serve as a lender of last resort to banks struggling to navigate turbulent economic waters. Twenty years later, the Depression rolled through and everybody was afraid that if the banks didn’t collapse under their own weight, a run would finish them off. Federal deposit insurance was created to curb this fear and protect not just depositors, but the financial institutions that serviced the American economy. At that time, the legislators point out, most banks had shareholder equity equal to between 15 and 20 percent of assets.

The trend from here is fairly well understood. As time wore on, a slow perversion of the original policy allowed big banks to reduce capital rations to as low as 3.5 percent of assets. At such a low ratio, very small reductions in the value of assets could force a bank into insolvency. Queue the housing bubble and the 2008 financial crisis.

The legislation that Brown and Vitter will introduce would require so-called megabanks — those with at least $500 billion in assets, such as JPMorgan (NYSE:JPM), Bank of America (NYSE:BAC), Citigroup (NYSE:C), and Wells Fargo (NYSE:WFC) — to maintain a capital ratio of 15 percent of assets. This is more than double the 6.9 percent held in 2012, and is also more than the 8.0 to 9.5 percent that is currently being discussed by international regulators.

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Brown and Vitter also argue that Basel III requirements are too weak, suggesting that a 4 percent reduction in the value of a bank’s assets could cause it to become insolvent.

“Requiring the largest banks to finance themselves with more equity and with less debt will provide them with a simple choice: they can either ensure they can weather the next crisis without a bailout, or they can become smaller,” the legislators wrote.

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