Monday, June 14, 2010

Collins Amendment Adds Leverage and Risk-Based Capital Requirements to Systemic Risk Title of Financial Legislation

Section 171 of the baseline financial reform legislation, authored by Senator Susan Collins, and inserted by way of amendment to the Restoring American Financial Stability Act on the Senate floor, would require financial firms to have adequate amounts of cash and other liquid assets to survive financial crisis. Federal regulators are directed to impose minimum leverage and risk-based capital requirements on banks, bank holding companies and nonbank financial firms such as investment banks and private funds that are identified by the new Financial Stability Oversight Council for enhanced supervision by the Federal Reserve.

According to Senator Collins, before this provision, no federal law required regulators to adjust capital standards for risk factors as financial institutions grew in size and engaged in risky practices. The provision ensures that bank holding companies and large nonbanks are held to the same capital and risk standards that are applied to insured banks in order to protect against excessive leverage that could destabilize the financial system. Cong. Record, May 10, 2010, p. 3460.

The provision would tighten the standards that would apply to larger financial institutions by requiring them to meet, at a minimum, the standards that already apply to small banks. According to Senator Collins, this makes sense because, if a small bank fails, the FDIC can close down that bank over a weekend, allow it to operate, avoid a run on the bank, and deal with
it in an orderly way. But if a large bank holding company or nonbank financial firm fails, it is so interconnected in the economy that it sets off a cascade of dire economic consequences.

Senator Collins also said that it is not intended that the provision should affect the treatment of small bank holding companies as provided under the Federal Reserve’s Small Bank Holding Company Policy Statement, nor does the provision apply to Federal Home Loan Banks Also, the effective date for bank holding companies owned by foreign banking corporations that obtained an exemption from capital requirements pursuant to the Federal Reserve’s Supervision and Regulation Letter SR-01-1 should be five years after enactment. Cong. Record, May 13, 2010, pp. 3710-3711.

According to Senator Dodd, the legislation requires heightened standards for leverage
and risk-based capital on large bank holding companies and on nonbank financial companies supervised by the Federal Reserve. These tougher standards will serve as speed bumps to keep financial companies from growing too large and risky and threatening the financial stability. The Collins provision would prevent regulators from weakening risk based capital and leverage standards. It effectively sets a floor for such standards going forward that would apply to all banks, bank holding companies, and nonbank financial companies supervised by the Federal Reserve.

The Collins provision also reinforces the legislation’s requirement that capital for large, interconnected financial financial companies should reflect the risks that their failure may pose to financial stability. The financial crisis revealed how dangerously overleveraged many large investment banks and other nonbank financial companies were. The Collins provision will ensure that the largest, most interconnected financial companies maintain a robust level of capital and eliminate gaps in capital standards between banks and other financial companies that could undermine financial stability. Cong. Record, May 14, 2010, S3774.

The FDIC strongly supported the Collins Amendment. In a May 7, 2010 letter to Senator Collins, Cong Record, May 10, 2010, p 3460, Exhibit 1, FDIC Chair Shelia Bair said that this provision is a critical element in ensuring that U.S. financial institutions hold sufficient capital to absorb losses during future periods of financial stress. With the new resolution authority in the legislation, taxpayers will no longer bail out large financial institutions. This makes it imperative that they have sufficient capital to stand on their own in times of adversity.

In the view of the FDIC Chair, the crisis also demonstrated the dangers of excessive leverage undertaken by large nonbanks outside of the scope of federal bank regulation. Notable examples included the excessive leverage of the largest investment banks during the run-up to the crisis. To remedy this and prevent regulatory gaps and arbitrage, large nonbank financial institutions deemed to be systemic must be held to the same, or higher, capital standards as those applying to banks and bank holding companies.

The Collins provision accomplishes this goal simply and directly. Finally, and more broadly, the crisis identified the dangers of a regulatory mindset focused exclusively on the soundness of individual banks without reference to the big picture. For example, an individual overnight repo may be safe, but widespread financing of illiquid securities with overnight repos left the system vulnerable to a liquidity crisis. A financial system-wide view requires regulators, working in conjunction with the new Financial Stability Oversight Council, to develop capital regulations to address the risks of activities that affect the broader financial system, beyond the bank that is engaging in the activity. May 7, 2010 letter to Senator Collins, Cong Record, May 10, 2010, p 3460, Exhibit 1.

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