Here’s the first paragraph from a FED press release of July 20th:
The Federal Reserve Board on Monday approved a final rule requiring the largest, most systemically important U.S. bank holding companies to further strengthen their capital positions. Under the rule, a firm that is identified as a global systemically important bank holding company, or GSIB, will have to hold additional capital to increase its resiliency in light of the greater threat it poses to the financial stability of the United States.
John Cochrane is happy to see this, as am I. However, he sees the biggest benefit as increased bank capital, and he seems to be arguing that there is no cost to firms for this. I think there are higher costs to the GSIBs, and I don’t think increased capital at banks is the major benefit of the regulation.
Remember, this regulation doesn’t apply to all banks, only ones identified as Global Systemically Important Banks (GSIB).
If GSIBs compete with non-GSIBs, they will have lower return on equity than non-GSIB for similar investments, a result of the math of leverage. That means they will have to pay more for capital.
Instead of increasing bank capital, it seems to me the FED is trying to get rid of Too Big To Fail (TBTF) banks. The increased capital works like a tax on GSIBs. They will have an incentive to break themselves up, creating more and smaller banks.
This is all good. The banking industry has been increasingly dominated by a very small number of very large banks. A larger number of smaller banks will increase competition and innovation.
There will be other impacts. My colleague Jeff Speaks points out that in addition to providing a competitive advantage for smaller banks, a desirable outcome, financial stability should be increased by reducing the probability of large bank failures.
Jeff adds that there may be a negative impact if GSIB respond to lower return on equity by increasing the riskiness of their investments. I suspect the FED believes its regulators can prevent this from happening.
This regulation came out the day before the fifth anniversary of Dodd-Frank. I wonder if the timing was deliberate. Dodd-Frank is a failed regulation that was, among other things, supposed to solve the problem of Too Big To Fail. Is the FED sending a message to Congress?