Brown-Vitter Bill Would Lead America to Economic Disaster

A draft of a new banking bill is in the works — sponsored by Senators Sherrod Brown (D-Ohio) and David Vitter (R-La.) — that introduces new regulations that are virtually impossible for banks to comply with without severely damaging to the economy.

While only in the draft stages, the Brown-Vitter bill illustrates the current train of thought on banking regulation circulating through the halls of Congress. But it seems that experts on the subject haven't had any input on it so far. Goldman Sachs released an analysis, dated April 10, on the possible economic effects this bill could have.

Essentially, the bill will mandate capital requirements to make sure that banks possess a certain minimum level of equity in an effort to prevent banks from over-leveraging. The bill will require banks to hold 10% of their capital, with an additional 5% for banks with over $400 billion in assets. The goal is to increase equity in the banking system by $1.1 trillion.

According to the report, banks, in their current form, would need almost 12 years of earnings to meet this requirement organically. However, the bill only gives them five years. Goldman believes that in order to hit this mark, bank lending capacity will be reduced by nearly $3.8 trillion, or roughly 25% of today's level. 

Banks affected by the 5% surcharge include juggernauts like Bank of America, Citigroup, Wells Fargo, and JP Morgan. In order to avoid the 5%, this bill would incentivize these banks to de-leverage. It sounds good, de-leveraging means banks will stop borrowing money to grow and expand, and instead focus on paying off outstanding debt. However, for investors (which includes anyone with a retirement plan or a pension or an employee who is partly paid in company stock), this will be a kick in the gut to their portfolios, and the stock market as a whole.

This is because a stock price generally only increases if people believe the share of the company they are buying will be worth more later. This requires the company to be in a constant state of growth. If there is no growth, the share of company they own will either stay the same value (in which case, they gain nothing by owning that stock and should put their money elsewhere), or far more likely, the stock they own will decrease in value. In either case, a large sell-off is imminent.

Even if the big banks managed to de-leverage and get themselves under the $400 billion mark, they'd still need to double their capital from the current levels to meet the requirements of this bill. Furthermore, one method of de-levering is selling off assets and pieces of the company. This means that Bank A, which made revenue in seven different ways (purely an example here), will only make revenue in three ways now, meaning the potential for future growth is also severely diminished.

Beyond that, given the decrease in lending that will have to occur, Goldman believes that the return on equity (ROE) banks get on average could fall to 5% (currently around 11%). ROE is the net income of an entity divided by the total amount of shareholder equity. 

For a very basic example, Company A generates $5/year and investors have put $100 into it. Therefore, the company is worth $100 initially, and $105 after the first year. The ROE for that year is 5%. 

A drop from 11% ROE to 5% ROE essentially means the profitability of banks would be cut in half. Not only would the ROE be less than the Cost of Capital (or the required return on an investment to make a capital expenditure, such as building a factor, or taking on debt, worthwhile)

This is not only a further blow to shareholders, but guarantees that it would be exceedingly difficult, if not mathematically impossible, for banks to meet the requirements of the bill without breaking themselves up.

Goldman puts it diplomatically, "We believe it possible that banks will struggle to raise this equity."

Seeking Alpha, an investment site, puts it a little less diplomatically, "The Brown/Vitter bill being rolled out in Congress is essentially Armageddon to the TBTF banks"

The end result of this is the highly impractical situation where "Too Big To Fail" banks, such as the ones listed above, would have to break themselves apart. These banks all have multiple entities worth more than $400 billion, and the bill is expected to impose restrictions on how these entities transfer money between each other. Even if the banks were able to get all pieces of themselves below $400 billion mark, each individual segment would still need to raise 10% equity individually, meaning for all their effort, the amount of relief they'd see would be modest at best.

The end result is not only that banking stocks would take a hit (and bring down anyone whose retirement relies on them along for the ride), but the banks themselves would be unable to lend nearly as much money as they do currently. If we recall the events of 2008, the lack of available credit to make home purchases, build factories, expand a small business, etc. was a principle catalyst for the Great Recession.

Hopefully, before this draft ever sees the light of day on the floor of the Senate, serious consideration into how much the banks must raise, and how long they have to raise it, must be made. The absolute worst possible thing we can do right now is prevent the banks from fulfilling their most basic function of lending money to people like you and me.