The latest round of bank "stress tests" show the banking system has gotten "much stronger" since the financial crisis, says Federal Reserve Chairman Ben Bernanke.
In a speech before a conference this week in Stone Mountain, Ga., Bernanke touted the results of the latest Federal Reserve stress tests, which showed all but one of the major banks and bank holding companies with assets of more than $50 billion could withstand a serious economic downturn without becoming insolvent.
"The results of the most recent stress tests and capital planning evaluations continue to reflect improvement in banks' condition," Bernanke said in the speech. "Higher capital puts these firms in a much better position to absorb future losses while continuing to fulfill their vital role in the economy."
The country's 18 largest banks have doubled the amount of the highest-grade capital reserves they have on hand from 5.6 percent of their assets to 11.3 percent between 2008 and 2012, an increase of more than $400 billion, Bernanke said.
However, those assurances seem to be falling on deaf ears in the Senate. A draft of legislation being put together by Sen. Sherrod Brown, D-Ohio, and Sen. David Vitter, R-La., which would put extra regulatory burdens on big banks, was leaked to Tim Fernholz of Quartz this week.
The draft calls for banks with more than $50 billion in assets to hold common equity that amounts to 10 percent of their assets, well beyond what's called for in the international banking standards known as Basel III. Banks with more than $400 billion in assets would be required to hold common equity that amounts to 15 percent of their assets, nearly double what's called for by Basel III.
Common equity is made up of retained earnings and common stock. In the event the bank runs into trouble and enters bankruptcy, it is common equity that is first siphoned off to satisfy the bank's debt obligations.
Generally speaking, when it comes to safety and soundness of banks, the larger that common equity buffer is, the better, because the next step after that buffer is used up is taking a bite out of bond holders and eventually, uninsured depositors, which can wreak economic havoc. Higher capital standards for banks that reach the thresholds specified in the legislation also may encourage banks to downsize or avoid excessive growth.
But those benefits don't come without a cost, says Greg McBride, CFA, senior financial analyst for Bankrate.com.
Banks primarily make money by taking on debt, either by issuing bonds or accepting deposits, and lending that money to consumers and businesses. The more common equity that banks have to hold relative to the amount they borrow and lend, the less profit they can make, McBride says. The cost also will fall to borrowers, who will likely pay higher interest rates for loans if the legislation eventually becomes law, and deposit account holders, who could see lower interest rates and higher fees, he says.
The plan also seems to take it as a given that assigning an arbitrary number for common equity will cure all ills when it comes to instability in the banking system, but that's not necessarily the case, says Mayra Rodriguez Valladares, managing partner at MRV Associates.
"Why 10? Why not 20 or 30?" Rodriguez Valladares says. "People are too hung up on the numbers. It has to be about getting banks to improve their risk management overall."
What do you think? Is the banking sector stronger, as Bernanke says? Is the answer forcing big banks to carry a bigger capital buffer?
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