What's the Deal with Capital Requirements?

The Senate is attempting to close the debate on financial regulation again today after yesterday's botched cloture vote due to a couple of Democratic defections and near-unanimous Republican descent. Word is the newest Republican maverick, Scott Brown, might change his mind and not vote to filibuster, but that still leaves the Dems one vote short, assuming Arlen Specter decides to bother coming back to Washington after his primary defeat on Tuesday.

Ok, great -- the Senate might pass it's version of the bill this week. But the story is still far from over on what the legislative sausage factory will produce, especially after the House and Senate bills go through reconciliation (it's not just for healthcare anymore!). That's one reason that some analysts are saying the Senate shouldn't be in such a hurry to close this debate.

One of the most contentious aspects of the bill as it now stands involves the issue of capital requirements for the banks -- how much money (or other various assets) they have to hold in order to ensure that they can pay back their lenders and cover their losses. An amendment proposed by Sen. Susan Collins (R-Maine) is at the center of this argument. Her change was unanimously passed last week, but only recently did it start to garner much attention, and it's many critics now include the Treasury, the Federal Reserve, and Wall Street:

"I don't believe that the senators understood the full implications of this amendment," said Edward Yingling, chief executive of the American Bankers Association trade group. "It would cause a severe capital crunch for many banks, resulting in the major decrease in lending capability."

U.S. and foreign bank regulators are working to complete new international capital requirements by the end of this year, and Treasury Department Secretary Timothy Geithner has made it one of his top goals. Sen. Collins's provision could affect those discussions by creating a new federal law mandating capital standards.

First, the banks' mantra that any and all financial regulation will "result in a major decrease in lending" is getting tiresome. It's true that right now the U.S. needs better, smoother credit flows, but once the economy is comfortably back on its feet, credit availability should be kept in check. That's the whole point of regulation -- remember excessively low interest rates and easy credit were a major factor in creating the financial mess in the first place. So claiming now that higher capital requirements will hurt banks' ability to lend is disingenuous. Although it might be an argument for phasing in higher capital requirements slowly.

This really seems to come down to a battle between the FDIC and the Treasury and the Fed about who will be in charge of setting and overseeing bank capital requirements. The latter institutions want more flexibility in determining these regulations both domestically and internationally. Recent events have shown that unilateral regulatory decisions can create havoc in the markets. Still, most observers have been saying for months that stricter capital requirements on the banks is one of the few no-brainers when it comes to financial reform. Demanding higher capital requirements now, but phasing them in once the economy is stronger might be the best solution because after the upswing takes hold, enacting solid and sensible reforms will only get harder. Plus, at least for now, if Wall Street is really pushing against it, you have to assume it's good.