A prominent financial regulator warned Wednesday that part of the government’s plan for ensuring that big banks can fail without receiving bailouts is a “gamble” that could have the effect of increasing the risks that Wall Street failures would pose to the economy.
In a speech delivered in Washington, Federal Deposit Insurance Corporation Vice Chairman Thomas Hoenig warned that regulators’ plan to require big banks to hold more debt that could be converted to equity in a bankruptcy could backfire by making the banks more leveraged and therefore riskier.
It is “paradoxical to suggest that the best way to manage the effects of excess leverage and financial vulnerability is to require more leverage, potentially raising financial vulnerability,” Hoenig told an audience at the Peterson Institute for International Economics.
“Adding leverage to the banking system in the hope that this will prove to be stabilizing is a gamble,” he added, later explaining that banks, under stress, could make riskier bets to avoid defaulting on the debt, thereby increasing danger.
Hoenig was referring to a rule proposed by the Federal Reserve in the fall that would require the eight biggest banks in the U.S. to maintain a certain level of “total loss-absorbing capacity,” which would entail the banks issuing new amounts of special long-term debt. The idea is that, if the bank failed, that long-term debt would facilitate an orderly failure at the bank without involving taxpayer money. If one of a megabank’s subsidiaries failed, the bank holding company’s shareholders would be wiped out, the long-term debt would be converted to equity and the former bondholders would become the new owners of the recapitalized bank. In other words, the existence of the special long-term debt would remove confusion and panic about which investors and creditors would get paid and which wouldn’t in the case of a failure.
Hoenig, known to favor more stringent rules on banks, noted that while some banks do have enough of the long-term debt required by the rule, others would have to issue new debt, possibly raising new risks. Rather than a one-size-fits-all rule, he said, regulators should tailor the requirements to each bank.
Megabanks also should face far higher capital requirements, he said, rather than debt that could be converted to capital. He suggested that the capital requirements could be twice as high as they are now, and that banks’ assets should not be “risk-weighted” to allow less capital for assets deemed safer by regulators. Other regulators and the Obama administration have touted the significant increase in capital levels since the financial crisis as evidence the system is safer.
Hoenig also downplayed the threat to the financial system posed by non-banks. The “shadow banking system,” comprising non-banks such as hedge funds and money-market mutual funds, is “not where the vulnerabilities lie,” he claimed. Instead, he argued, the real risk is that a leveraged megabank would fail.
Although Hoenig did not mention the presidential race, his comment has applicability to the Democratic primary. Hillary Clinton, currently ahead in polls, has argued that her plan to regulate shadow banking makes her more credible than her opponent, Sen. Bernie Sanders of Vermont. Sanders, in contrast, has advocated a blunter approach of breaking up the big banks and re-imposing a form of the Glass-Steagall Act, a 1933 law that created barriers between commercial banks with insured deposits and investment banks that underwrite and trade securities.
