Regulators' calculations were "were wrong when it came to subprime mortgages [and] they were wrong when they were talking about Greek debt," said Rep. Scott Garrett in support of banks hitting a non-risk-based leverage ratio.
Regulators' calculations were "were wrong when it came to subprime mortgages [and] they were wrong when they were talking about Greek debt," said Rep. Scott Garrett in support of banks hitting a non-risk-based leverage ratio. Bloomberg News

The debate over a Republican bill to overhaul the Dodd-Frank Act is increasingly focused on two widely different philosophies about capital regulation, which were both on display at a hearing Tuesday.

In one camp, supporters of House Financial Services Committee Chairman Jeb Hensarling's bill think regulators should throw out the complicated and malleable risk-based capital formulas of the Basel Committee in favor of a bare-bones leverage ratio, which no longer uses risk classifications for different types of assets.

But lawmakers and others opposed to the legislation say Hensarling's approach, which would exempt banks meeting a 10% leverage ratio from Basel and numerous Dodd-Frank provisions, is too extreme. While a leverage ratio would require several banks to raise significantly more capital, critics warn that taking risk weights out of the equation will encourage riskier activities.

In testimony prepared for the hearing, which was the first on Hensarling's bill, Georgetown University law Professor Adam Levitin pointed out that risk weights are "imprecise," "politicized" and "gameable."

"A simple leverage ratio avoids all of those problems. On the other hand, a simple leverage ratio incentivizes banks to [take on] riskier — and thus higher-yielding — assets," he said. "The CHOICE Act, unfortunately, would adopt a simple leverage ratio while eliminating the regulatory tools necessary to prevent banks from gaming the simple leverage ratio by seeking out high-risk assets."

Many argue that Basel's risk-based capital regime contributed to the financial crisis, saying that the risk weights for certain assets were too arbitrary while the regime allows institutions to design an asset composition that massages regulatory capital levels. But Democrats at the hearing suggested that a better solution than a non-risk-based system is to make risk weights more precise.

"Some people complain that the problem with the risk weights before the crisis was that the risk-weights were inaccurate," said Rep. Carolyn Maloney D-N.Y. But, she added, "Under the chairman's bill, the solution is…even less accurate risk weights."

Maloney's comments echoed those of Federal Reserve Board Gov. Daniel Tarullo, who last week argued that using a simple leverage ratio essentially treats all assets on the balance sheet the same when some are inherently riskier than others.

"If [the simple leverage ratio] were the only requirement put in place, then banks would be incentivized to move towards much riskier assets because their capital requirements wouldn't change," Tarullo said.

But Hensarling and supporters of the bill stressed that simplifying the capital regime not only has the benefit of requiring higher capital, but also would free banks from the time-wasting task of complying with risk-based capital requirements to devote more time to helping their communities benefit from economic growth. The 10% leverage ratio, which is voluntary under the legislation, would exempt banks from certain liquidity requirements as well as the Basel regime and stress testing.

"The Financial CHOICE Act will relieve financial institutions from growth strangling regulations that create more economic burden than benefit in exchange for voluntarily meeting higher, yet simpler, capital requirements," Hensarling said in his opening statement.

John Allison, a former BB&T chief executive and former CEO of the Cato Institute, said the current regulatory reforms aren't working.

"The banks today are focused on making regulators happy instead of going out and making loans," Allison said. "It is a big mistake to believe that regulators know the proper level of risk…They are tightening standards way too much and it is hurting the normal growth rate of the economy."

Rep. Scott Garrett, R-N.J., argued that the regulators and the Basel committee have a poor track record of identifying risk.

Regulators "were wrong when it came to subprime mortgages, saying that they were less risky, they were wrong when they were talking about Greek debt being less risky than some corporate bonds," Garrett said.

"Doesn't Tarullo totally, absolutely, 100% miss the point?" Garrett added. "These were the banks being incentivized to move into riskier assets. Should we recognize that [banks] were already encouraged to under Basel and the prudential regulators?"

In his opening statement, Hensarling agreed, saying the Basel Committee's risk-based capital regime was "discredited" and had proven to be "destructive during the last crisis."

But the top Democrat on the committee, Maxine Waters, D-Calif., said allowing banks to get an exemption from Dodd-Frank provisions by achieving a 10% leverage ratio would effectively give them a free pass from regulatory reforms. She also drew a distinction between Hensarling's bill and the leverage ratio proposals of other policymakers who have consistently backed tougher regulation.

"While credible financial reformers have proposed strengthening capital requirements in exchange for some regulatory relief for community banks," Hensarling's proposal "is not that bill," Waters said.

"In fact, it takes the names of true financial experts in vain, by stealing their ideas and weakening them," she said.

Waters added that the proposal "contains none of the guardrails of other proposals, including limits on banks' derivatives activity."

One of the most outspoken proponents of moving to a 10% leverage ratio is Federal Deposit Insurance Corp. Vice Chairman Thomas Hoenig. However, Hoenig has generally been in favor of stronger regulatory oversight for banks, particularly large ones, not less regulation. Hensarling's bill would eliminate certain Dodd-Frank provisions heralded by financial reform backers, such as the Volcker Rule ban on banks' proprietary trading.

Levitin said that although Hensarling's proposal has been billed as a way to help community banks, Wall Street would reap most of the benefits.

"It will help" community banks and megabanks, "but it is going to help megabanks more than it is going to help community banks," Levitin said. "The choice lets everyone opt out of Basel III, but the Choice Act also lets megabanks opt out of Dodd-Frank's prudential standards and out of other certain longstanding provisions."

However, Jeremy Newell, executive managing director and general counsel at The Clearing House Association, which represents some of the largest banks, said he opposed moving to a simple leverage ratio.

"Although the leverage ratio is seen as an alternative to risk-based measures of capital, the leverage ratio is in fact also a risk-based measure of capital, albeit a bad one," Newell said in prepared remarks.

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