Summer is, sadly, so over.  Whatever the fate of the massive legislation to rewrite financial regulation, Treasury has sent out a blistering policy statement on regulatory capital that proves yet again that new rules will break big banks apart even if Congress doesn’t.  We think Congress will act, albeit differing with Treasury on who should regulate systemic institutions.  But, should it demur, Treasury and bank regulators have now laid out just how much it will cost to conduct banking in concert with non-traditional activities like proprietary trading.  As with the inter-affiliate transaction ban discussed in the past, the capital rules are seemingly technical, but they will have profound strategic impact and don’t need a nick of new law to implement.

Like the regulators, Treasury is in a foul mood over industry capitalization.  One can, of course, emphasize even as we recall that policy-makers were in happy cahoots with big banks over the capital regime that wreaked such havoc.  Repenting of past sins, though, regulators are going full bore for a sweeping rewrite that will not only hike capital, but also do so in selective ways that disentangle complex banking organizations and soon the structured products once so beloved by the big boys.

There’s been a lot of talk about a public-utility model for Fannie Mae and Freddie Mac, but far less focus on it as the new regulatory regime for major financial-services firms.  Treasury doesn’t even whisper the term in its policy statement, but it’s still the Administration’s bottom line for big banks.  As with the systemic-risk rules, new inter-affiliate transaction restrictions and non-traditional activity ban, the capital rules would rewrite the return-on-equity expectations on which most big-bank strategies remain premised. 

How so? Take, for example, the list of activities that Treasury says should draw higher regulatory capital.  This is the first time we’ve ever seen such a list, although we understand it was put together in concert with the newly-wary banking agencies.  What’s on the hit list?  Proprietary trading, as we mentioned, but also a raft of less-explosive activities like securities lending and borrowing.  This would force a redo not only of new BHCs like Goldman Sachs, but also of more traditional specialized banks that have grown huge in securities-related transactions in recent years.  Treasury has also nailed credit derivatives and similar commitments, a move that will force the market back to capitalized forms of credit risk mitigation.  This spells a breath of hope for monoline bond insurers – at least new ones – as well as for other providers of capitalized credit-risk protection.   

Some big banks may take a look at this list and laugh, based on the view that all they need to do is move cited businesses from the bank into non-bank subsidiaries and go merrily along.  The SEC is years away from rewriting broker-dealer capital rules, although it scrapped the consolidated-supervised-entity one following the demise of these once-so-favored firms.  With a clear field outside the bank regulators, big institutions will hope to move hedge funds, private-equity operations, securities lending and similar activities into non-bank subsidiaries.  Treasury is, though, on to this. The policy paper, like the initial reform white paper, says that financial holding companies should have capital consolidated at the parent level, not just judged at bank subsidiaries.  The Basel rules already require consolidation at the parent-company level.  Although most institutions have yet even to think this through, let alone implement it, Treasury’s plan doesn’t require new law, just action on pending rules.

Treasury’s capital policy is focused on several post-crisis objectives.  Among these are an end to procyclicality so that capital and other regulatory standards cease to promote booms and bust.  Another goal is better incentive alignment – the policy for the first time details new forms of capital designed to ensure that shareholder dollars are really at risk.  In fact, Treasury now says that capital should be more than a buffer  between risk and the taxpayer; it wants capital instead to force shareholders to make management do right long before risks rise to crisis level.  The new capital regime also enhances the capital-at-risk framework Treasury is pushing to reform asset securitization.

But, behind all these stated goals is an unspoken one:  blow too big to fail to smithereens.  The more regulations – especially potent ones like capital requirements – make it difficult to operate a financial colossus with opaque intra-industry risk exposures, the more Treasury pries apart the interconnectedness that precipitates systemic risk.  Policy won’t mandate skinnier banks – Treasury rejects Germany’s proposal for explicit asset-size limits – but banks will have no choice but to restructure themselves into separate, specialized entities with capitalized exposures to a far smaller number of counterparties.