The Federal Reserve Board recently adopted far-reaching reforms in the way American banks are regulated. On balance they are a sensible reaction to changes in the banking industry since the market crash of 2008, but they should be strengthened by reform in the way banks keep their books
The reforms, based on a law enacted by Congress in May over the strenuous objection of Sen. Elizabeth Warren, D-Mass., will relieve all but the six largest banks of many of the onerous and costly regulatory oversight procedures mandated by the 2010 Dodd-Frank reform law for all major banks. These six banks together own about half of all bank assets in the United States. They are JPMorgan Chase, Bank of America, Wells Fargo, Citigroup, Goldman Sachs and Morgan Stanley.
Together with previous decisions this year by the Fed, that should make it less profitable to be a mega-bank known as a Systematically Important Financial Institution or “too big to fail.” At the same time, the new reforms should improve the bottom line for smaller institutions, which will not have to maintain as large a capital buffer as the six mega-banks or face the same costly regulatory oversight. That does not completely solve the “too big to fail” problem, which would require breaking up the mega-banks. But it does put the brakes on the further growth of the problem.
Specifically, the Fed has decided to reduce the capital buffer for eight banks ranging in size from $250 billion to $700 billion in assets, although these banks will still have to undergo the Fed’s costly stress tests. Another 24 banks with assets between $100 billion and $250 billion get even looser capital and oversight requirements, except for banks with significant overseas exposure. The law passed by Congress last spring frees another six banks with assets of $50 billion or more, the original level set by Dodd-Frank, from “advanced” supervision. It also reduces regulations for banks with less than $10 billion in assets.
A welcome likely effect of the new regulations will be to slow the consolidation of the banking industry by improving the bottom lines of smaller institutions. Between 1984 and 2018 the number of U.S. banks covered by the Federal Deposit Insurance Corp. has fallen by about 70 percent, from over 18,000 to less than 6,000, and the size of mega-banks has grown rapidly as they bought up smaller banks. That will now be less profitable.
Banks make money by lending. The larger the volume of loans they can make for a given amount of capital, the more money they can make. But the higher this leverage, the more a bank risks failure when some of its loans fail to be repaid.
The new reforms effectively reduce the leverage of the mega-banks and increase the leverage of all other banks while reducing their regulatory requirements.
But along with this shift comes a higher risk of failure. One of the ways banks get in trouble is by ignoring the riskiness of their loan portfolio and failing to take steps to reduce it.
Under current accounting rules banks may book an asset, such as a loan, at its initial book value until that transaction is completed, either profitably or not.
That should change. If banks were required to “mark to market” all of their assets, the bad ones as well as the good ones, they would have to increase their capital reserves to cover anticipated losses. The private, nonprofit organization that oversees financial accounting standards has proposed such a reform, which would work like an automatic brake on risky lending.
The banking lobby has worked overtime to obtain relief from Dodd-Frank. It now strenuously opposes this accounting change proposed by the Financial Accounting Standard Board. The arguments put forward by the banks for retaining the old rule are self-serving and not in the public interest. Congress should not intervene to prevent the proposed rule from becoming the standard in the banking industry.