A Serious Look at the SAFE Banking Act

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Would the current bills on financial reform have made a difference if enacted in 2007? As critics on both the left and right have pointed out, the Dodd proposal does not seriously address the size or risk-taking behavior of large banks that caused the crisis. Regulators already had the vast majority of the tools necessary to combat the crisis before it happened, and better resolution (or bankruptcy) authority by itself does little to combat the problems of risk-taking and moral hazard that fueled lax lending.

The “SAFE Banking Act” amendment by Senators Brown and Kaufman deserves a serious look in that context. Their proposal puts hard size restrictions on the megabanks – limiting deposits held by any bank to 10% of overall deposits; holding non-deposit liabilities to 2% of GDP (and overall liabilities limited to 3% of GDP) – as well as tight leverage requirements on all banks and financial institutions mandating a minimum of 6% of overall assets held as capital. The rules are targeted at the largest “Too-Big-to-Fail” banks – including Citibank, Bank of America, and JP Morgan – which would be required to drastically reduce in size.

A focus on making banks smaller is in line with a long American political tradition pushing for smaller banks – a pressure behind America’s historically high bank failure rates. Pre-Depression banking limited the ability of banks to open new branches. As a consequence, individual banks were less stable, and failed far more often in comparison to their geographically diversified counterparts in Canada. The S&L crisis, too, was sparked by small thrift organizations. A systematic study by Ross Levine and several co-authors found that concentrated banking systems were less likely to have banking crises. Nor is managing crises easier when banks are smaller. Research by Viral Acharya and Tanju Yorulmazer suggests that smaller banks may have incentives to “herd” together in lending practices. As Larry Summers suggested in an interview with PBS NewsHour, the simultaneous failure of numerous smaller banks could be as bad or worse than the failures of a few financial institutions.

The real advantage of having smaller banks lies in the assumption that smaller banks will not be sufficiently politically connected to ask for bailouts, or be systematically important enough to merit bailouts. But it’s not obvious that it’s the size of banks that contributes to their political clout. Bear Stearns was not a large bank when it failed – but it was highly inter-connected with other financial institutions. The counterparty risk posed by Bears Stearns’ derivative positions can be mitigated by moving them to an exchange. But as long as the financial ecosystem remains dependent on funding provided by shadow banks, regulators will find reasons to bail them out; and as long as those institutions remain dependent on repos and other short-term debt, they will be extremely fragile.

The leverage restrictions implied by the bill are serious, and echo demands made by virtually every serious financial commentator crossing party lines. But enforcing these restrictions will prove a challenge. As Steve Waldman has pointed out, capital is tough to measure. Lehman, for instance, would have passed the SAFE leverage requirements right up the point at which it failed. Banks can and did game leverage requirements through off-balance sheet vehicles like SIVs; and even if all current loopholes get closed, new ones will surely be invented. Broadly speaking, trying to regulate banking activity through hard caps and restrictions is like playing whack-a-mole. As long as banks believe themselves to be benefitting from Too-Big-to-Fail subsidies, there will be enormous profits to be gained through regulatory arbitrage that skirts the caps. If banks genuinely want to take on risk, it’s hard for regulators to stop them. Prudential regulations need to be accompanied with corporate governance reforms that limit the fundamental desire (or behavior) of banks to seek risk; and better resolution authority mechanisms (like Hart-Zingales-Papagianis, or other Convertible Capital proposals) that put more of the losses caused by faulty risk-management on CEOs and bond-holders, rather than taxpayers.

Still, Brown and Kaufman deserve praise for advancing a serious proposal to deal with the over-riding problem of the systemic risk posed by implicit bailout guarantees. It’s fair to say that the banking world of 2007 – which is rapidly returning – will cause a severe financial crisis every ten years or so. At some point, the losses will exceed the capacity of the government balance sheet, and the consequences will be truly staggering.