Financial reform has taken a prominent role in the current presidential debates, particularly between Clinton and Sanders. As Clinton is seen as the candidate of the status quo, her defenders have taken to arguing that the Dodd-Frank Act is “working.”
A recent example of such an argument is Paul Krugman’s claim that, thanks to Dodd-Frank, “banks are being forced to hold more capital." But is Krugman's claim true?
Before turning to the numbers, we should consider just how capital has been regulated before and since Dodd-Frank. Prior to Dodd-Frank, the primary source of regulatory authority for capital was found in Section 38 of the Federal Deposit Insurance Act (FDIA). The relevant clauses of that section read as follows:
(c) CAPITAL STANDARDS.–
(1) RELEVANT CAPITAL MEASURES.–
(A) IN GENERAL.–Except as provided in subparagraph (B)(ii), the capital standards prescribed by each appropriate Federal banking agency shall include–
(i) a leverage limit; and
(ii) a risk-based capital requirement.
(B) OTHER CAPITAL MEASURES.–An appropriate Federal banking agency may, by regulation–
(i) establish any additional relevant capital measures to carry out the purpose of this section; or
(ii) rescind any relevant capital measure required under subparagraph (A) upon determining (with the concurrence of the other Federal banking agencies) that the measure is no longer an appropriate means for carrying out the purpose of this section.
The first thing to notice is the lack of a ceiling. Although Section 38(c)(3)(B) requires that a bank’s capital be “not less than 2 percent of total assets,” there’s no maximum. Also notice how 38(c)(1)(B)(i) above allows regulators to set additional capital requirements. In plain English, bank regulators, prior to Dodd-Frank, could have pretty much required whatever capital levels they wanted.
It was under this FDIA authority that U.S. bank regulators began the “Basel III” process, the first consultative paper for which was published in December 2009, a good seven months before Dodd-Frank was signed into law. Basel III itself was introduced in December 2010, and most of the work of implementing Basel III had been completed before Dodd-Frank’s passage. Despite what Paul Krugman says, the increases in bank capital that have occurred since the crisis, in so far as they were a result of changes in the law, were largely a consequence of these developments, rather than of Dodd-Frank. Were Dodd-Frank to be repealed in its entirety, our current bank capital standards would largely be unchanged.
Hasn’t Dodd-Frank also helped? It’s true that Dodd-Frank is not without some mention of capital. The “Collins Amendment” (Section 171) mandates that capital requirements for bank holding companies be no less stringent than those applied to depositories. Setting aside the fact that the previous law already allowed regulators to impose the same requirement, the fact is that this additional regulation doesn’t matter much, because most holding companies have few assets relative to their subsidiaries. Let’s also set aside the fact that the average observed Tier I capital for holding companies at the time of Dodd-Frank was already equal to that for depositories.
The Collins Amendment to Dodd-Frank also restricted the use of trust preferred securities (TruPS) as capital. But here again, although the restriction is sensible, bank regulators already had the ability to insist upon it. More importantly TruPS, at the time of Dodd-Frank, represented only about 11 percent of Tier 1 capital for bank holding companies. So while the Federal Reserve should have never affirmatively approved of the use of TruPS as capital (another fine regulatory decision by the Fed), TruPS were never more than a relatively small portion of capital. If that’s what counts as “reform” then color me unimpressed.
Section 165 of Dodd-Frank goes further than these other measures, by setting a minimum leverage requirement for the largest banks. It is one of the few capital regulations in Dodd-Frank that could make a difference. Unfortunately, at just 6%, the requirement is quite low. The minimum is also not based on assets-to-equity but on debt-to-equity. In other words, the change is largely cosmetic.
OK, enough with the law. Just how much has bank capital increased since the passage of Dodd-Frank? It all depends on what you mean by capital. According to the FDIC, at the end of 2015, commercial banks had “total equity capital” of $1.8 trillion. This is certainly higher than the $1.5 trillion that existed at the time of Dodd-Frank’s passage. But bank assets also increased. What matters is the ratio of bank capital to total bank assets. At the passage of Dodd-Frank that ratio was 11.1. At year-end 2015, it was 11.2. So much for Krugman’s massive increase in bank capital.
The minor increase in the overall bank capital-to-assets ratio becomes even less impressive when one realizes that it has been driven almost exclusively, not by new legal requirements, whether from Dodd-Frank of from Basel III, but by an increase in banks’ “undivided profits” — that is, in banks’ retained earnings that have yet to be distributed to shareholders. When most people think of capital, they mean the sort that represents “skin in the game,” or common equity. So what’s been the trend there? At the passage of Dodd-Frank, banks held $55.5 billion in common stock and perpetual preferred shares. At year-end 2015, that number was $52.7 billion. This decline is even more shocking when measured relative to assets, falling from 0.4 percent of assets to 0.3 percent of assets. Seems the so called claim about increased bank capital isn’t actually true, if you look at what most people would consider capital. There are still other ways to look at capital. The chart below, from the FDIC, illustrates the trend in the four most commonly used capital ratios. Total risk-based capital, the top line, actually shows a decline since the passage of Dodd-Frank. The other three measures show very minor increases. I’d say they were essentially flat. And even that relatively weak trend is the result of the Basel process, not Dodd-Frank.
Some apparent increases in bank capital relative to risk-weighted assets are due to the fact that banks have massively shifted into low risk-weight assets. Under a system of risk weighted capital, the required capital is a function of the target capital level times the risk weight of the volume of the asset. For example whole mortgages have historically had a risk weight of 50%. So if one holds $100 million in whole mortgages and the target capital is 8%, then actual capital is not $8 million but rather $4 million (8 x 0.5). Needless to say the risk weights have come under considerable scrutiny, especially since assets like Greek government debt were given risk weights of zero.
Since Dodd-Frank, commercial banks have more than doubled their holdings of U.S. Treasuries, which require zero capital. Banks have also increased their holdings of mortgage-backed securities and municipal debt, which also have low risk weights. The point is that banks haven’t really raised lots of new capital as much as they’ve gamed the risk-weights to appear to have more capital (apparently they’ve fooled Krugman).
Now there are lots of reasons to like or dislike Dodd-Frank. Its impact on bank capital isn’t one of those reasons, as said impact has largely been illusionary.