Understanding Brown-Vitter

The release of the Brown-Vitter bill in the Senate has garnered a lot of attention in the financial press for being a bipartisan effort to curb the too big too fail (TBTF) phenomenon in banking.  The way that Brown-Vitter attempts to do this is by making being big more expensive. Specifically, it would increase the capital requirements for all but small banks:

• Mid-sized and regional banks would be required to hold eight percent in capital to cover their assets
• Megabanks – institutions with more than $500 billion in assets – would be required to meet a new 15 percent capital requirement
• Community banks would remain unchanged by the legislation, as the market already requires them to maintain capital ratios approaching 10 percent of their assets,

So what exactly is “capital?” Matt Levine of the Planet Money team has a very simple great description: 

Capital is how much money would be left in the bank if you sold all the bank’s stuff and paid off all its debts.

The rationale for taking this approach is simple. Raising capital requirements reduces the degree to which banks fund their operations with borrowing, thereby lowering leverage ratios. As Anat Admati and Martin Hellwig put in in their influential new book, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do about It, “significantly reducing the reliance of large banks on borrowing is the most straightfoward and cost-effective approach to crisis prevention.”***

There have been plenty of endorsements of the plan. Simon Johnson offers a representative one:

The dangers of reckless behavior by global megabanks are now understood much more broadly. And Brown-Vitter provides an appropriate road map for addressing some of the core problems and making the financial system significantly safer.

The Independent Community Bankers Association has also come out strongly in support.

“All community bankers, state trade groups should tell Senators to support Brown/Vitter S. 798” -@cam_fine ow.ly/kZi1x #TBTF

— ICBA (@ICBA) May 14, 2013

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Of course, the bill also has plenty of opponents, led by the big banks. Quite simply, they aren’t thrilled with the prospect of their capital requirements being increased. Mark Roe describes their position:

Shareholders and senior managers on Wall Street do not want banks to use more equity financing because debt financing with government back-up is cheaper.

There is also pushback on the idea that the best way to limit systemic risk is to focus on absolute size. For example, James Chessen, an economist for the American Bankers Association, argues that leverage ratios offer “little useful information on the safety and soundness of a bank” and that “a risk-based ratio does a much better job distinguishing banks that go on to fail from those that survive.”

What do these disagreement over the merits of the bill tell us about its likelihood of passage? Does it have a shot at actually being signed into law? Preliminary evidence suggests that is pretty unlikely. GovTrack’s logit model finds that the bill has only an 8% chance of making it out of committee and only a 1% chance of getting signed into law. An anecdote supports this prognosis: one of the four original co-sponsors of S.798 had only four original co-sponsors, Mark Kirk (D-IL), has already withdrawn his support (he gave no public explanation for the reversal). Thus, it is pretty clear that, at least for now, this bipartisan reform plan faces an uphill battle. Still, it’s important to remember such efforts are more appropriately viewed with a long time horizon. Maybe this right-left coalition will lose this battle, but it doesn't necessarily mean they’ll lose the war to end TBTF.

***Full disclosure: I provided a very small contribution to this project, working as a research assistant to Anat Admati for several weeks during the manuscript revision process.