| A bill introduced by U.S. Rep. Michael Capuano (D-Mass.) seeks to quantify the government support received by the nation’s biggest financial institutions and to link that to their credit risk advantages. So far, the political landscape’s response has been the equivalent of: “That’s a good question … that we wish you hadn’t asked.”
At press time, HR 2266, also known as the Subsidy Reserve Act of 2013, didn’t yet have a co-sponsor. It raises issues already gaining global attention, most notably by the International Monetary Fund (IMF) and by the Federal Reserve Bank of New York. But gathering the data it seeks might be the equivalent of trying to unbake a cake.
The bill, first submitted by Capuano last June, calls for financial institutions with assets of $500 billion or more to establish and maintain a subsidiary reserve, to annually identify on their balance sheets the portion of retained earnings attributable to government support, and, in addition, to report the market advantage they realize from that support. It couldn’t be applied toward Basel III requirements and it could only be reduced by divestiture or other reduction of risk exposure.
‘Too Important To Fail’
The issues go far beyond U.S. borders. A March 31 survey for IMF’s Global Financial Stability Report, analyzing the situation in the eurozone and Japan, reinforces the notion that large financial institutions benefit from government support, including loan guarantees and direct injection of public funds. The survey found that banks regarded as “too important to fail” (the IMF’s term) borrow at lower rates and take bigger risks than those without that implicit distinction. The IMF survey called for policymakers to remove this advantage to protect taxpayers and ensure a level playing field between large and small institutions.
Capuano’s bill seeks to get U.S. lawmakers to do the same thing. The Federal Reserve Bank of New York recently authored a report that the top five financial institutions in the country benefit from federal backstops. HR 2266 calls for the board of the Federal Reserve to write a formula to quantify government support. If the financial institution’s shareholders deem the capital requirement as defined by the Fed board is too high, they’d have the choice to downsize the bank by selling assets or divesting units on a pro rata basis, or according to the risk weighting of the property spun off, sold or divested. Any other reduction of funds in the subsidiary reserve would be prohibited.
Professor Cornelius Hurley, director of the Boston University Center for Finance, Law & Policy, is an original envisioner of HR 2266. He says the incentive to deleverage and right-size is critical, but that large financial institutions are not likely to independently confirm that they receive subsidies. He cites an article by Mark J. Roe, slated for the University Pennsylvania Law Review, that lays out the scenario that downsizing, despite being advocated by internal management, is counterindicated by the funding value the firm realizes by its very too-big-to-fail size. Hurley observes that because of this dynamic, any subsidiary of a large bank becomes less valuable to a buyer than it would be to the bank. And that’s the dynamic that needs to change, Hurley indicates.
Inactive Ingredients
Developing a workable formula to determine the subsidiary fund would be extremely difficult, says Lawrence G. Baxter, professor of law at Duke University, due to the many forms that government support takes. The IMF survey shows that government subsidy for the U.S. banking system is also significantly lower than in many other countries, he says.
A subsidy reserve could also take many forms, he adds. Would it be a form of retained earnings or undistributed capital, or, a portion of bank funding that should be dedicated to investment in safe assets, such as Federal Reserve funds or U.S. Treasuries? Could it be applied to loans?
The subsidy reserve would require more shareholder funds than depositor funds, requiring shareholders to hold more equity capital, making the subsidy reserve a form of calibrated additional capital, Baxter says.
Additionally, if government subsidies vary widely across regions and nations, he questions whether this would call for the U.S. to impose a “countervailing duty” on banks that receive more subsidies from their host nations, such as Germany? (This starts to sound like tariffs and customs.)
Ultimately, he says, “a subsidy requirement will have capital allocation implications for the economy as a whole. So it would be important to understand the implications of not being able to distribute subsidy reserves as dividends: Is it most efficient to tie capital up in the banking industry rather than allow it to be distributed into other areas of investment?”
This last point brings up the potential of a two-tiered financial system in which some form of capital is more liquid than another. Holding capital at below-market investment opportunities is a hard concept for free-market advocates to stomach, but anyone who remembers what mark-to-market did to the financial system in 2008 might be able to put it in context.
Email: coneill@thewarrengroup.com
