Karen Shaw Petrou memorandum to Federal Financial Analytics Clients on the FRB’s organic-death plan for U.S. G-SIBs.

TO: Federal Financial Analytics Clients

FROM: Karen Shaw Petrou

DATE: July 10, 2015

FRB Governor Lael Brainard yesterday sent a chill through the already quivering hearts of the largest U.S. banks, saying that the new G-SIB surcharge would not just hike their minimum risk-based capital, but would also be laid into CCAR to set the effective minimums even higher. That was so scary that some missed an even more important point: Ms. Brainard believes that all of these rules should cost big banks so dearly that they voluntarily give themselves up and become smaller, less complex, and thereby less systemic. Think of this as the obverse of organic growth, the long-cherished strategy in which banks get larger without resort to M&A. What the FRB is after is what I’ll call organic death – the FRB doesn’t by rule tear them asunder, but behemoths nonetheless self-dismember.

Gov. Brainards’ construct is based on a theorem: if a G-SIBs’ failure costs the economy five times more than that of a less-systemic bank, then its capital should be big enough to make its likelihood of failure one-fifth as high. How the FRB measures either the cost of a G-SIBs’ failure versus that of a smaller BHC or how it precisely maps the correlation between capital and default risk is not described.

I’ve not seen research to this effect anywhere, although the FRB from time to time tempts one with bits of these analytics. If the Board in fact knows just how much capital makes a financial institution how much safer, it would do the world a service by disclosing it. But, empowered by what it says it knows, the FRB is nonetheless marching toward turning negative externalities inside out to charge big banks for what it says they’ll cost.

Unlike the FRB, I can’t say how much risk would drop with how much capital, but I can say how much capital will lead to how much earnings. The correlation here is a lot more clear and quantifiable than the suggested linking of capital and failure risk. The more capital, the lower the return on equity unless earnings keep pace with capital hikes. So far, they haven’t and there’s little sign that banks – big or small – will regain ROE anytime soon for an array of reasons, regulations very much among them.

Some have countered that higher capital doesn’t lead to lower investor return because investors cozy up to low-risk banks, thus demanding less of a risk premium in return for their hard-earned dollars. Academic research does not, however, support this, nor does it bolster assertions that higher capital leads to lower-risk assets.

More capital is good for less prudential risk, but the correlation isn’t an infinite rainbow to paradise, as the Brainard correlation above suggests. To be sure, Gov. Brainard does recognize that, even if more capital is always better, it’s never free. Hence the hope that big banks will see the error of their charters and eviscerate themselves.

Joining FRB-NY President Dudley and Gov. Tarullo, Ms. Brainard yesterday said that the government is no guide to real value in a corporate redesign. Her thinking is, in essence, pile it on and they’ll fall apart on their own into sensible, smaller pieces.

Smaller these pieces would be, but more sensible? Investors would surely get a short-term pop because at least some of the smaller parts would have less of an immediate regulatory burden and, thus, higher ROEs. But, could a custody bank really operate without an affiliated asset manager? One line of business is critical to the financial system, but also a very low-margin. Could a gigantic branch banking system use core deposits just for nice little loans or would the cost of gathering funds force the retail operations into new, smaller regional banks – okay so far – and dry up the capital-market operations now also conducted in the largest banks? You might say okay to that too, but then where do securitization, primary dealing, underwriting, and market-making go?

Into the shadows? That might be fine – more risky activities would head out with far less of an express federal backstop, or so it seems. However, the FRB is already talking about establishing a “market-maker of last resort” for asset managers and broker-dealers. It’s talking this up because the central bank fears the systemic risk already skipping over the regulatory fence to the happier climes of less-regulated financial institutions. Better return for less regulatory capital for companies outside of the banking corral for sure. Lower risk? Let’s see some FRB research proving that.

G-SIBs