SAFE Banking Act, What it Does in 2D

Let’s talk about the SAFE Banking Act. First up, what does it do? Well, it caps deposits at 10% of total deposits, non-deposit liabilities at 2% of GDP for banks and 3% of GDP for non-banks. Huh? Let’s put it on a 2d graph:

Banks take in money, and lend out money. The riskier the money they take in, the more likely it is you’ll have a bank run. On the y-axis we have the amount of deposits a firm has. Because of FDIC insurance and the federal reserve window, deposits are fairly sticky, even in a crisis (have you worried about a bank run?). This bill would reinforce that one bank can’t have more than 10% of the total deposit base, which is around $800 billion.

But what about non-deposits? What about liabilities like obligations in the repo market and other shadow deposits, liabilities very subject to shadow bank runs? That will be on our x-axis. The SAFE Banking Act would limit this to 2% of GDP for banks, and 3% of GDP for non-banks. Right now that is about $280 billion, and $420 billion respectively.

Notice that this axis is where the shadow banking run happens. This is where banks take on debt to use for lending that isn’t deposit based. So why not at least put a ring-fence around how large this can get for any single firm? This can at least put some sort of limit on how interconnected a firm can get into the capital markets, so if our other regulatory efforts fail we at least have some boundaries on the damage.

A lot of people say “Lehman wasn’t that big!” and it is true compared to the even larger firms. (Though it was a massive firm.) But the bigger firms were all shadow banks that also have a giant deposit base. So even though other firms may have been bigger, since their liabilities were far less riskier the damage was more contained.

Let’s take a look at who this would effect:

Remember the idea of two problems with size: something like Wells Fargo which is huge but not a shadow banks, and something that has huge exposures in the shadow banking market but wasn’t that big. And then there is the problem of both, which is what we face.

A lot of people are against a size cap because they think there isn’t a problem with “too big” per se. The size cap people are way ahead of this critique, which is why we’ve all been pushing for a cap on liabilities that aren’t relatively safe deposits.

Again, if you really believe Basel III is going to solve this, run with it. I’d encourage you to leave a link with a story about Basel III negotiations going well, because I’ve never heard any. (If you like having nightmares, start reading the lobbying letters on Basel III. My god.) And we are putting all of our eggs in this basket.

e21 has a critique of the SAFE Banking Act, where among other things they bring up that the leverage cap wouldn’t have done much. But remember the leverage ratio people are talking about when they mention Lehman passing is net leverage ratio. The SAFE Banking Act would be total leverage ratio, and it would move it from the current 3% to a new 6%. (That’s 16.67:1.)

On this definition, the banks were definitely leveraged following a 2004 SEC report. A graph from Boston Fed shows this:

Remember to deleverage a firm of that size would cause a firesale on the assets, which would increase leverage again. So it’s very, very difficult to get this down once it is this inflated (see Lehman in 2008).

So getting a hard rule around the size of your shadow banking enterprise, as well as a hard rule around the leverage a massive firm can take. What’s not to like?

Also, fyi, House Financial Services Committee Members Reps. Brad Miller (D-NC), Keith Ellison (D-MN), Steve Cohen (D-TN), and Rep. Ben Chandler (D-KY) just introduced this into the House.

This entry was posted in Uncategorized. Bookmark the permalink.

9 Responses to SAFE Banking Act, What it Does in 2D

  1. Mike says:

    Yes, I now see that I misspelled vulnerable in that graph.

  2. Jamie says:

    How on earth is “pushing for a cap on liabilities that aren’t relatively safe deposits” a rebuttal to the argument that it’s not about size per se? (Answer: it’s not.)

    I don’t think anyone from the break-up-the-banks crowd has offered a single coherent response to the argument that it’s not about size. Mostly you people just agree that it’s not necessarily about size, but then offer the weak defense of, “Well, breaking up the banks would help.” Uh, no, it wouldn’t. By your own “standards,” the SAFE Banking Act is useless. It would force banks to shrink to the size of….Bear Stearns. One of the few banks in history that was officially deemed “too big to fail”! So how, again, would the SAFE Banking Act make anything safer? The intellectual incoherence of the break-up-the-banks argument is amazing.

  3. joel says:

    Perhaps I missed this, but I’m assuming this proposal makes banks small enough to fail?

  4. Mike says:

    Jamie,

    I said it’s not a problem of size, it’s a problem of liabilities. And it’s not really a problem of liabilities of deposits, but a problem of liabilities of the shadow banking market.

    As a bank becomes abnormally large, it is difficult to adjust assets to reduce leverage without moving the market against your assets, and everyone else’s. (And let’s be clear. If you have a trillion dollars in non-deposit liabilities, it is virtually impossible.)

    So I think capping the amount of non-deposit liabilities, along with a leverage requirement (ideally graduated, but this is good too), will put firms more in the place where problems can be detected early, political pressure can be avoided, and they can credibly be put into a resolution mechanism without tearing down the entire market.

    But, I’ll bite: are you are satisfied that Basel III will take care of everything?

  5. erdosfan says:

    Mike,

    Let’s assume arguendo that we have 1 bank, B, with liabilities totaling X, such that X exceeds the threshold under the rule above. Now let’s break that bank into 100 smaller banks, {b1,..,b100}, such that the liabilities of each little b is equal to X/100. Let’s also assume that X/100 is less than the threshold under the rule so we don’t need to subdivide the banks any further to comply with the rule.

    Assume that collectively, the little b’s have the same asset portfolio as the big B. That is, if we aggregate over the set of assets owned by the little b’s, we would get the same portfolio of assets owned by the big B (this is exactly what would happen if you split up a large bank). If the assets owned by the little b’s under perform and as such the little b’s don’t have enough regulatory capital, they have to either (i) sell assets or (ii) raise equity. These are the same options that the big B would have in this situation. Moreover, the same amount of capital must be raised whether that capital is raised by a bunch of small banks or one large bank. And what’s worse, you don’t have one single entity timing the sale. You have 100 small entities, each competing to sell first.

  6. Jamie says:

    Mike,

    1. The big banks have been aggressively deleveraging and derisking since the beginning of 2009, and there’s been a definitive upward trend in markets across the board over that same time period. All you’ve offered is a theoretically plausible argument — not something on which a major new era in banking regulation should be based. This is the big-leagues now.

    2. I’m not going to bite at your false dilemma. Opposing the SAFE Banking Act is not the same as putting all your eggs in the Basel III basket, and you know it. The administration’s approach is multi-faceted, and doesn’t hinge on any one aspect (like Basel III). The derisking of the financial sector comes from a combination of the resolution authority, prompt corrective action being applied to LCFIs, higher capital requirements, higher capital charges for non-cleared and bespoke derivatives, and the first global liquidity requirements regime ever. (And if you knew anything at all about Basel III, you’d know that the proposed liquidity requirements will be brutal on — and safer for — the banking industry.) Claiming that the choice is between enacting the SAFE Banking Act and putting all our eggs in the Basel III basket might fool journalists and bloggers, who apparently look up to you on these issues. But you’re not convincing anyone who knows what they’re talking about on financial regulation.

  7. Mike says:

    Jamie,

    Yes after taxpayers ring fenced half a trillion dollars worth of debt in off-balance sheets and the Federal Reserve took incredibly aggressive actions, the big banks were able to reduce their leverage.

    I’ve never said that this should be the base of a new era of banking regulation, I’m saying it is a supplement to the regime that Treasury et al have announced. I’m a huge supporter of higher capital charges for derivatives, PCA, etc., and have written about them extensively. But I don’t think they will be used to shrink the top end by having seriously heavier requirements.

    We will see what happens with Basel III, but I know the lobbying efforts have been intense on the global liquidity front. But the real fear for me right now on the resolution side are (a) is regulatory forebearance with PCA (b) regulators being sideswiped by liquidity in short-term lending as a repeat of shadow banking runs (c) that the capital requirements won’t actually be more aggressive than smaller firms, or that off-balance sheet and budgetary manipulation will make it meaningless (d) lending through the Fed in the next crisis will bias towards risky and largest and most shadow-bank like players; and least likely but most scary (e) cost of capital goes low for the biggest players because of a combination of above and the market not reading resolution as credible (ie GSEs). All these worries are mollified by less concentration at the top end.

    That’s before the political argument, and the argument that the bailouts themselves have solidified and increased the concentration of the biggest players at the expense of the smaller and medium sized ones, which are arguments I take very seriously.

    What’s your take on coco bonds? Or separately, a hard leverage cap?

  8. Pingback: FT Alphaville » Further reading

  9. Pingback: So much coverage to report on

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s