Momentum is building in Washington for a reform that would make extremely large banks less threatening to the U.S. economy. Opponents are calling it “radical.” What’s actually radical -- and dangerously so -- is the behavior it seeks to change.

Two senators, Democrat Sherrod Brown of Ohio and Republican David Vitter of Louisiana, plan to offer a bill that would require banks to finance their businesses with more equity from shareholders, as opposed to money borrowed from creditors. An early draft, which takes up all of five pages, sets a simple minimum of $1 in equity for each $10 in assets -- a measure far easier to understand and enforce than the complex, risk-weighted capital ratios that global regulators currently favor. For the largest banks, the requirement would be $1.50 per $10 in assets, or 15 percent.

The proposal is aimed at removing a major incentive for banks to engage in unduly risky behavior: The more damaging a bank’s failure would be to the economy, the more certain its creditors can be that the government will come to the rescue in an emergency. This too-big-to-fail status allows banks to borrow money at lower rates than they otherwise would -- a taxpayer-funded subsidy that encourages them to borrow recklessly, bloats the financial sector and helps inflate credit bubbles.

Boosting Equity

Boosting equity levels addresses two problems at once. By increasing the role of shareholders, who are first in line to absorb any losses, the measure would make banks less likely to fail. If a bank has 10 percent equity, also known as capital, the value of its assets would have to decline 10 percent to render it insolvent. Current U.S. rules require banks to have capital of only 4 percent of assets, and use a lenient approach to calculate the ratio.

Also, higher equity would expose the largest banks to market discipline by reducing their access to taxpayer-subsidized debt. They would have to compete with smaller institutions and independent asset managers on a more equal footing, a challenge that would test their all-in-one business models and almost certainly reduce their profitability. Faced with this reality, shareholders might rethink the generous pay packages that executives enjoy, or even consider breaking down the banks into more manageable and efficient units.

Banks have sought to characterize the senators’ proposal as radical, portraying 10 percent or 15 percent capital as an anachronism from the days before federal deposit insurance and other 20th-century innovations. As Financial Services Forum Chief Executive Officer Rob Nichols, a senior bank lobbyist, put it: “Raising required capital to comically high levels will severely restrict banks’ ability to lend to businesses and job creators.”

It would be more accurate to say the current level of equity at the largest U.S. banks is comically low. The typical U.S. enterprise has equity of about 70 percent of assets. Research by economists at the Bank of England and a new book by financial economists Anat Admati and Martin Hellwig suggest that banks need equity of at least 20 percent to avoid failures. Under international accounting standards, which are more stringent than U.S. rules, the five largest U.S. banks by assets -- JPMorgan Chase & Co, Citigroup Inc., Bank of America Corp., Morgan Stanley and Goldman Sachs Group Inc. -- had an average tangible equity ratio of only 3.2 percent as of mid-2012. At the same time, they commanded more than $14 trillion in assets, almost equal to the U.S. economy’s entire annual output.

No Argument

The argument that more equity would restrict banks’ ability to lend doesn’t stand up to scrutiny. Capital is not a rainy-day fund that banks must set aside for emergencies. It is money they can use to make loans. If banks raised more equity from shareholders, their lending capacity would increase -- particularly in times of crisis, when the added capital would shield them from distress. If investors don’t want to provide a bank with equity, that’s a comment on the quality of the enterprise and its management, not an adverse effect of overweening regulation.

Tellingly, the equity requirements in the senators’ proposal would be a stretch primarily for the small group of giant banks whose assets exceed the $400 billion threshold at which the proposed 15 percent ratio kicks in. Rightly so: These are precisely the institutions that have benefited most from the taxpayer subsidy. Among 493 smaller banks tracked by Bloomberg, the average tangible common-equity ratio was almost 9 percent as of their latest financial filings. This is already very close to the 10 percent requirement they would have to meet.

In other words, there’s nothing outrageous -- and very much that is sensible -- in the ideas of Senators Brown and Vitter. May lawmakers keep that in mind if and when the bill comes to a vote.

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