The skirmishing is almost over, the main armies almost assembled. Ahead is a great battle over the future of our financial system that could have more profound consequences than the Dodd-Frank legislation of 2010.

The battleground is the hearts and minds -- and fears -- of the seven people who make up the board of governors of the Federal Reserve System. The critical contest will be about bank capital and how large financial institutions should fund themselves. The fog of war has masked the terrain, so that even well-informed bank lobbyists don’t realize they have wandered into a potentially disadvantageous position.

It remains to be seen whether the Fed can make the most of this real opportunity for reform. Too many governors still seem encumbered by a flawed mental model of how megabanks work.

The headlines continue to focus on the international agreement regarding capital requirements -- known as Basel III - - and how it will be implemented in the U.S. There are interesting questions here, including what the Fed will decide regarding the so-called SIFI surcharge (the extra equity funding required for systemically important financial institutions).

Basel Standards

For the most part, however, the Basel-related changes are meaningless. The Basel deal is, at its core, about “risk-weighted capital,” and this is the wrong way to think about banks’ balance sheets. As experts such as Tom Hoenig, the vice chairman of the Federal Deposit Insurance Corporation, and Morris Goldstein, a longtime International Monetary Fund official (and my colleague at the Peterson Institute for International Economics) argue, all that we really know about risk weights is that, in every crisis, they are completely wrong.

Management is free to use risk weights for internal purposes (and good luck with that), but capital regulation needs to be about the true ability to absorb losses relative to total assets. Regulators should focus on this measure -- known as leverage -- and its implications for what happens when a financial company faces failure.

“We must end too big to fail” is the refrain now heard from regulators and big-bank representatives (seriously, they say this with a straight face). And the main mechanism that they propose is the resolution powers granted to the FDIC under Title II of the Dodd-Frank Act.

The FDIC’s proposed approach calls for losses in any part of a financial holding company to be absorbed by the holding company. Absorption here is a polite term for wiping out the equity and converting debt into equity.

Ideally, bank holding companies would be funded with a lot more equity. But the Fed has already signaled that it will wimp out on this issue -- with “we agreed to this in Basel” as a smokescreen. Equity levels will remain too low to make a difference.

The bank lobbyists are cheering. After all, big banks like to borrow heavily, increasing the upside for executives but also creating more downside for the rest of us.

But here is the rub. The FDIC’s approach to resolution only remotely makes sense if there is enough “bail-in-able capital” at the holding company. (I’m on the FDIC’s Systemic Resolution Advisory Committee; my views are mine alone.)

According to reasonable independent estimates, some of our largest financial holding companies have very little such bail-in capacity -- Moody’s Investors Service estimates that JPMorgan Chase & Co. has 5 percent. (This is Moody’s assessment of what could be used to recapitalize the group, divided by total assets of the group; avoid thinking about risk weights in this context.)

‘Loss-Absorbing’

The Fed now needs to rule on how much bail-in-able capital there must be in this form. And it also needs to set rules about who holds the relevant types of debt. “Loss-absorbing debt” cannot be held by other leveraged institutions or by any institution prone to a run -- such as a money-market fund. In this case, a company-specific event can easily become systemic panic.

If the Fed waits even six months, it will destroy any chance of the FDIC establishing credibility for its Title II resolution mechanism. People in the credit markets are already highly skeptical that the FDIC will be able to implement this effectively.

The big banks are preparing to complain that this bail-in-able capital is “expensive” and therefore should be set at a low level. But the precise point is that creditors should lend to holding companies only at a high rate of interest, reflecting the downside protection given to, among others, creditors who lend to the operating subsidiaries. The latter get a greater degree of protection under the FDIC’s plan, with a big chunk of that protection supposedly provided by creditors to the holding company.

Remember the debts that can pile up at those subsidiaries, particularly when risk management is weak. (For a relatively small-scale and transparent illustration, see the case of JPMorgan’s London Whale and the losses amassed by the bank’s trader Bruno Iksil.) Crazy loans and losses in 2007-08 represent the nightmare scenario on a grand scale, but not necessarily the worst that could happen. Lenders to the holding company should be very skeptical and deeply scared -- and charge accordingly.

Global megabanks are profoundly complex, and intentionally so. Investors and regulators don’t know what risks are being taken. Board members also are usually in the dark. Whether top management understands what is happening is an open question: Chief Executive Officer Jamie Dimon is adamant that he had no real knowledge of JPMorgan’s Whale positions, which eventually had a notional value in the trillions of dollars.

Pricing Risk

Megabanks say they want to end “too big to fail.” This statement will only be credible if investors see and price the risk inherent in lending to holding companies. If you don’t see a large spread between loans to the operating subsidiary and loans to the holding company, then nothing has happened.

For this policy to work, the Fed has to require the price of debt to megabank holding companies to increase. Everything else is an illusion.

Some Fed board members (perhaps two of them) have shown some appreciation for this point, at least in private conversations. Others shy away from the reality of pricing risk appropriately.

The Fed will draw serious political support if it moves to increase bail-in-able capital into the range of 20 percent to 30 percent of total assets for large-bank holding companies (with some colleagues, this is what I have proposed). The central bank will draw great ire if it sides with the megabanks, again.

The Fed has to decide. Should it make Title II resolution meaningful and allow a real chance of reducing the risks posed by the biggest financial institutions? Or should it shy away from a decisive victory?

On current form, the Fed seems likely to fail us, again.

(Simon Johnson, a professor at the MIT Sloan School of Management and a senior fellow at the Peterson Institute for International Economics, is co-author of “White House Burning: The Founding Fathers, Our National Debt, and Why It Matters to You.” The opinions expressed are his own.)

To contact the writer of this article: Simon Johnson at sjohnson@mit.edu

To contact the editor responsible for this article: Max Berley at mberley@bloomberg.net