There are a lot of things you can read about the Brown-Vitter bill recently, though it’s a really nice day out and you Aprobably shouldn’t. It’s not … it’s not like a real thing is it? When the text of the bill, which would raise the equity capital requirements on big banks to ~15% on a non-risk-weighted basis and forbid U.S. regulators from implementing Basel rules, first leaked, I sort of assumed it was a temper tantrum not intended to become law, and the fact that its official title is the “Terminating Bailouts for Taxpayer Fairness (TBTF) (Get It?) (GET IT?) Act of 2013″ doesn’t exactly change my mind.

I seem to have company in that view. Here you can read Jesse Eisinger (pro-Brown-Vitter) saying it’s a “barbaric yawp” that “probably won’t get passed.” Here you can read Davis Polk (anti) agreeing. Here you can read Matt Taibbi (very pro) saying that it might.2 So you figure it out.

Here’s one thing though, which is:

  • Here you are with $100 in Pretty Safe Assets funded with like $5 of Capital and $95 of Debt.
  • Suddenly you need $15 in Capital.
  • You’re not going to take that lying down.
  • You sell the Pretty Safe Assets to Quintilian Regulatory Fucking-About Partners, a hedge fund, for $100.3
  • You buy a call option on the Pretty Safe Assets from QRFAP, struck at say $70, which has a fair value of about $30 since it’s way way in the money and the Pretty Safe Assets are, by hypothesis, not that volatile.
  • Your sources and uses are:

QRFAP paid you $100 for the assets;

You paid QRFAP $30 for the option;

You spend the remaining $70 paying down debt.

  • So you now have $30 of assets funded with $5 in Capital and $25 in Debt, which gives you about a 17% Capital Ratio, which is A-okay.
  • Good work you.

I’m sure this oversimplifies4 but you get the idea. But I’ll spell it out anyway, which is: risk-based capital measures imperfectly aim to reduce this arbitrage by basically requiring more capital against riskier assets than they require against less risky assets.5 “Riskier assets” is not a question of the inherent goodness of the underlying stuff. “Riskier assets” just means things whose value on your balance sheet is likely to change by a larger percentage. Your $100 in Pretty Safe Assets probably wasn’t going to lose more than $5 of value, or 5% of your assets, in a short time period. Your $30 in call option on Pretty Safe Assets can lose $5 in value in the same time period, but that’s now 17% of the assets it represents.

This isn’t necessarily all that terrible: after all, you have in some sense reduced your risk, insofar as in the very unlikely case that your Pretty Safe Assets lose more than $30 you’re off the hook for them. But you’re pretty far into your creditors’ money by that point anyway, and you might consider that the point of capital buffers is mostly to avoid that result.

Source : Wall street journal