MacroScope

Too-big-to-fail banks are bigger than ever before. But top regulators tell us not to worry. They say the problem has been diminished by financial reforms that give the authorities enhanced powers to wind down large financial institutions. Moreover, supervisors say, the new rules discourage firms from getting too large in the first place by forcing them to raise more equity than they had prior to the financial meltdown of 2007-2008.

New York Fed President and former Goldman Sachs partner William Dudley said in a recent speech:

There has already been considerable progress in forcing firms to bolster their capital and liquidity resources. On the capital side, consistent with the Dodd-Frank Act, Basel III significantly raises the quantity and quality of capital required of internationally active bank holding companies. This ensures that the firm’s shareholders will bear all the firm’s losses across a much wider range of scenarios than before. This should strengthen market discipline. Meanwhile, to the extent that some of the specific activities that generate significant externalities are now subject to higher capital charges, this should cause banks to alter their business activities in ways that reduce both the likelihood and social cost of their failure.

Moreover, the new Basel regime explicitly adjusts capital requirements upward based on size, complexity, interconnectedness, global exposure and substitutability – attributes that are proxies for the negative externalities generated by failure. If a bank is deemed a global systemic financial institution or G-SIFI, then it will have to hold a greater amount of capital relative to its risk-weighted assets compared to a less systemic institution.

One could make a good case that the capital surcharge for systemically important firms should be higher than that contemplated by the Basel Committee.

But for proponents of much higher capital requirements that would force banks to rely less heavily on leverage, there is no question. They argue Basel III changes are not nearly sufficient to allow supervisors – and therefore taxpayers, who are still on the hook for these supersized financial firms – to sleep soundly.

We’re pretty sure that Daniel Tarullo, the Federal Reserve’s point person on regulation, expects the United States will finally understand exactly what financial reforms are coming “some time next year.” But the Fed governor made doubly sure to qualify that statement lest anyone – especially any press “in the back” – take it as gospel.

At a conference in New York Wednesday morning, Tarullo was asked how long it would take for the various regulatory agencies to give final details on the raft of financial crisis-inspired reforms, everything from Basel III capital standards to the Volcker ban on proprietary trading. Here’s what he said:

“I know it’s frustrating for people not to have the proposed rules out. On the other hand, doing them simultaneously does allow us to see whether something in one of the proposed capital rules will affect something in another proposed capital rule, so that we end up, when we publish the final rules, with fewer anomalies, questions and the like, which will undermine the ability of a firm or academic or just anyone in the public to see and understand how these things are going to function. I hesitate to give a time line on exactly when we’ll get there. But I think…it seems to be reasonable to expect that some time next year the basic outlines – and I don’t just mean the ideas, I mean the details associated with the major reform elements – should be reasonably clear to people even though questions will inevitably rise in implementation. (You) don’t want to take that as a promise. But as I think about these various streams, that is my expectation… To have gotten it done this year would have meant the sheer magnitude of the task would have lead to a lot of inconsistencies or open questions, which then would have just produced another round of change. So you’ve got me on the record saying some time next year, but I tried to qualify it as much as possible – that’s for all you people in the back…”

On the basis of "stress tests" it ran, the Federal Reserve has given permission to most of the largest U.S. banks to "return capital" to their shareholders. JPMorgan Chase announced that it would buy back as much as $15 billion of its stock and raise its quarterly dividend to 30 cents a share, up from 25 cents a share.

Allowing the payouts to equity is misguided. It exposes the economy to unnecessary risks without valid justification.

Money paid to shareholders (or managers) is no longer available to pay creditors. Share buybacks and dividend payments reduce the banks’ ability to absorb losses without becoming distressed. When a large “systemic” bank is distressed, the ripple effects are felt throughout the economy. We may all feel the consequences.