There are a lot of things you can read about the Brown-Vitter bill recently, though it’s a really nice day out and you probably shouldn’t. It’s not … it’s not like a real thing is it? When the text of the bill, which would raise the equity capital requirements on big banks to ~15% on a non-risk-weighted basis and forbid U.S. regulators from implementing Basel rules, first leaked, I sort of assumed it was a temper tantrum not intended to become law, and the fact that its official title is the “Terminating Bailouts for Taxpayer Fairness (TBTF) (Get It?) (GET IT?) Act of 2013″ doesn’t exactly change my mind.1

I seem to have company in that view. Here you can read Jesse Eisinger (pro-Brown-Vitter) saying it’s a “barbaric yawp” that “probably won’t get passed.” Here you can read Davis Polk (anti) agreeing. Here you can read Matt Taibbi (very pro) saying that it might.2 So you figure it out.

Here’s one thing though, which is:

  • Here you are with $100 in Pretty Safe Assets funded with like $5 of Capital and $95 of Debt.
  • Suddenly you need $15 in Capital.
  • You’re not going to take that lying down.
  • You sell the Pretty Safe Assets to Quintilian Regulatory Fucking-About Partners, a hedge fund, for $100.3
  • You buy a call option on the Pretty Safe Assets from QRFAP, struck at say $70, which has a fair value of about $30 since it’s way way way in the money and the Pretty Safe Assets are, by hypothesis, not that volatile.
  • Your sources and uses are:
    • QRFAP paid you $100 for the assets;
    • You paid QRFAP $30 for the option;
    • You spend the remaining $70 paying down debt.
  • So you now have $30 of assets funded with $5 in Capital and $25 in Debt, which gives you about a 17% Capital Ratio, which is A-okay.
  • Good work you.

I’m sure this oversimplifies4 but you get the idea. But I’ll spell it out anyway, which is: risk-based capital measures imperfectly aim to reduce this arbitrage by basically requiring more capital against riskier assets than they require against less risky assets.5 “Riskier assets” is not a question of the inherent goodness of the underlying stuff. “Riskier assets” just means things whose value on your balance sheet is likely to change by a larger percentage. Your $100 in Pretty Safe Assets probably wasn’t going to lose more than $5 of value, or 5% of your assets, in a short time period. Your $30 in call option on Pretty Safe Assets can lose $5 in value in the same time period, but that’s now 17% of the assets it represents.

This isn’t necessarily all that terrible: after all, you have in some sense reduced your risk, insofar as in the very unlikely case that your Pretty Safe Assets lose more than $30 you’re off the hook for them. But you’re pretty far into your creditors’ money by that point anyway, and you might consider that the point of capital buffers is mostly to avoid that result.

Now, it’s not really clear that this sort of thing would be allowed in a Brown-Vitter world. (Obviously the intensive lobbying against Brown-Vitter suggests it wouldn’t, or not seamlessly.) The text of the bill doesn’t prohibit risk-based capital regulation. Or, rather, it sort of does prohibit risk-based capital regulation, but it seems to think that “banking supervision” – basically “the Fed should say no to trades like this,” I think? – will fill in the gap:

Except as provided in paragraph (2), nothing in this section shall be interpreted to prevent any appropriate Federal banking agency from establishing supplemental risk based capital requirements for any financial institution with more than $20,000,000,000 in total consolidated assets …

(2) LIMITATION.—
(A) JOINT DETERMINATION.—An appropriate Federal banking agency may not implement risk-based capital requirements with respect to a financial institution with more than $20,000,000,000, unless all appropriate Federal banking agencies agree that bank supervision is
10 insufficient to prevent the excessive concentration of riskier assets.
(B) REPORT TO CONGRESS.—Before proposing risk based capital rules described in this subsection, the appropriate Federal banking
15 agencies shall submit a joint report to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives detailing the deficiency in supervisory tools in preventing investment in excessive amounts of riskier assets and how risk based capital will be used.

I think that says “the Fed should just tell banks not to do risky trades, but if they really can’t do that then they should write it 100 times and submit that to Congress and then they can have risk-based capital regulation.” Or something.

The Brown-Vitter text also has an anti-evasion provision, which prohibits “Any attempt by a financial institution to structure any activity, transaction, or affiliation for the purpose or effect of evading or attempting to evade the asset threshold that gives rise to the surcharge” on banks with over $500 billion in assets. So you can’t do anything for the purpose of looking like you’re an under-$500-billion bank, including, as Davis Polk points out, becoming a smaller bank.6

But there’s no equivalent prohibition on structuring activities to reduce your assets for capital purposes – only for threshold purposes. Presumably because a no-reducing-assets provision would make it impossible to do most of the transactions that banks do (why did you do a swap instead of buying outright? etc.).

We’ve talked before about how bank risk-to-equity remains roughly constant, and in a new world without risk-based capital regulation there’s no particular reason to think that would change. One possible mechanism for maintaining constant risk-to-equity would be to invest in riskier assets; another would be to find new ways to structure investments in the same assets. Given the uniform capital requirements, you could imagine the winners in a Brown-Vitter world being the bankers who are most aggressive about risk-taking and structuring. What’s not to like?

Brown, Vitter Unveil Legislation That Would End “Too Big To Fail” Policies [Senate, with bill text]
In Brown-Vitter Bill, a Banking Overhaul With Possible Teeth [DealBook]
Too-Big-to-Fail Takes Another Body Blow [Matt Taibbi]
Brown-Vitter Bill [Davis Polk]
Brown-Vitter Bill: Game-Changing Regulation For U.S. Banks [S&P, registration required]

1. Incidentally, spot the changes from the leaked draft! I noticed two:

  • The initial draft basically counted all credit commitments as assets, which is pretty rough for, say, JPMorgan with over a trillion dollars of unfunded credit facility commitments. The new draft “exclud[es] commitments to lend, whereby certain provisions and or covenants exist that limit the risk to the bank holding company with respect to future draws of liquidity,” which, um, I guess is meant to exclude revolvers? I dunno.
  • The initial draft seemed – and was a bit unclear honestly – to require 10% capital for banks under $400bn in assets, and a sliding scale up to at most 15% for banks over $400bn. The new draft is 8% for banks between $50bn and $500bn and at least 15% for banks over $500bn. The sliding scale seems to have been abandoned.

2. Here you can read S&P’s take, which doesn’t give a likelihood of passage, but which does sort of say “ending TBTF would be bad for bank creditors because banks might fail”:

It is tempting to assume that we would raise credit ratings because higher capital increases creditworthiness to bondholders. Indeed, there is added protection to bondholders. However, we look more broadly at funding and liquidity issues that may arise during a transition period, as well as the business positions of the six largest banks likely to be affected, especially because we would expect this legislation to create a significant incentive for these banks to break apart. The implications of the bill could be negative from a ratings standpoint if their franchises lose business and revenue diversification as well as competitive strength and also experience depressed profitability, becoming less attractive investments and likely experiencing more limited access to capital. … Under our methodology, we would potentially no longer factor in government support if we believed that once large banks are broken up, we would not classify these banks as having high systemic importance.

Which is kind of funny and which Matt Taibbi rightly calls them on. But they’re not wrong, are they?

3. Obviously, like, 99% debt funded. Shadow banking!

4. An even more oversimplified approach would be to sell the Pretty Safe Assets and then buy them back on swap, though that probably doesn’t let you de-recognize the asset under US GAAP. But it might work as a way to buy future assets. Though there are increasingly swap collateralization requirements, which seem to be based on 5-day 99%ile moves. My 5% initial margin translates to an asset with about a 15.5% annual price volatility, which is, like … Spanish government bonds, or US utility stocks. Safe-ish.

But you can build things that are intermediate between the swap and just the call option. For instance you sell QRFAP a $60 strike put for, like, zero dollars, to go along with the $70 call that you bought from them. So your risk is pretty close to the original position.

5. Oh needless to say that doesn’t always avoid regulatory arbitrage. It’s worth saying why though, which is basically that the regulatory arbitrage takes advantage of discrete steps between regulatory capital treatment: if regulatory capital treatment perfectly mapped to market perceptions of risk there’d be no benefit to regulatory capital arbitrage. If regulatory capital treatment is perfectly orthogonal to market perceptions of risk – if there’s no risk weighting – then there’ll be infinite benefit to regulatory capital arbitrage, more or less.

6. Take it away boys:

Read literally, these provisions could prevent a Financial Institution with $500 billion or more in total assets from selling assets to shrink its balance sheet below $500 billion, surely a strange result if the point of the Brown-Vitter bill is to discourage the formation or continued operation of the largest banking organizations.

Compare the fact that the Volcker Rule is sort of intended to prevent FDIC insured banks from engaging in prop trading, but that everyone thinks that if Goldman tried to not be an FDIC insured bank any more it’d probably still be subject to the Volcker Rule. You can’t get out.

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Comments (2)

  1. Posted by QRFAR Gold Fund | May 1, 2013 at 6:38 PM

    No risk weighting is not sufficient for the set to be orthogonal. You have to have random risk weighting for <x,y> = 0. Which would be pretty awesome. Can we get that bill? The wheel of fortune based risk weighting plan?

    Or you can have random market risk perception.. Like Paulson for example.

    I still give any article that pulls that gem out of the linear algebra textbook an A+.

  2. Posted by Funsouk | July 6, 2013 at 4:17 AM

    Good effort and very well written. Thanks for sharing.