In Fed’s Move on Capital One Deal, a Test of Dodd-Frank
By STEVEN M. DAVIDOFF
Capital One is the latest bank accused of being “too big to fail.”
A proposed $9.2 billion purchase of the online bank ING Direct would make Capital One the fifth-largest bank in the United States with more than $200 billion in deposits.
But before this acquisition can be completed, it requires clearance from the Federal Reserve, Capital One’s chief regulator. The Dodd-Frank Act requires that the Federal Reserve weigh the systemic risk of the combined company. If the risk outweighs the benefits of the transaction, the deal must be blocked.
The Fed has yet to decide what constitutes a systemically risky acquisition. So its decision on Capital One could have a broad impact on what Dodd-Frank means for the nation’s biggest banks.
Community interest groups led by the National Community Reinvestment Coalition, which oppose the deal, say that Capital One is already classified under Dodd-Frank as systemically important since it has more than $50 billion in assets. Why should any such bank be allowed to get bigger?
Moreover, Capital One is likely to use ING Direct’s deposits to finance its main business: credit card issuance. And Capital One is moving to expand significantly in this debt-driven consumer credit sector. Earlier this month, Capital One announced the acquisition of HSBC’s $30 billion credit card portfolio in the United States. After the HSBC deal, Capital One will remain the United State’s fifth-largest credit card issuer, but its market share will rise to about 9 percent from 7 percent.
National Community suggests that this will result in ever more credit cards at high-interest rates being pushed to American consumers who presumably can’t fend for themselves.
Because the Federal Reserve has yet to spell out its own “too big to fail” guidelines, Capital One has proposed its own test to the Fed. Capital One looks at bank size and its interconnectedness and importance to the financial system. Not surprisingly, Capital One fails to meet this criteria. The bank rightly notes that after the two acquisitions, it would still be a pipsqueak next to Bank of America, the largest United States bank with $2.26 trillion in assets. Capital One will have only a measly $300 billion or so. How could this increase systemic risk?
Moreover, Capital One argues that it does not engage in the complex type of banking that a Goldman Sachs or Morgan Stanley does, like writing derivatives. Capital One is going to be a simple, deposit-taking institution that lends money primarily on credit cards.
Some analysts have said that the ING Direct acquisition will make Capital One sounder because it will provide Capital One a more stable source of financing for its lending activities than borrowing in the short-term lending market.
Who is right?
Clarity, if not an answer, may have come inadvertently from National Community. The coalition argues that Capital One’s application to acquire ING Direct is suspect because Capital One refuses to lower its credit standards to extend Federal Housing Administration-insured loans to people with credit scores of 580. This is the lowest credit score allowed by the F.H.A. National Community contends that this is discriminatory against members of minority groups because they tend to have lower credit scores and have been hit harder by the financial crisis.
Capital One has responded by agreeing to lower its credit score requirements by 2012. For National Community, this is not enough, because Capital One’s F.H.A. loan volume is relatively flat in growth. Capital One is now a bit player with less than 1 percent of the F.H.A. loan market. National Community wants the combined entity to make more of these loans, since they help people who could not otherwise afford a mortgage.
So National Community is arguing that Capital One should take more risk when making home loans, but less risk in getting bigger and offering credit cards. Remember, the financial crisis was caused in significant part by excessive, and sometimes predatory, subprime lending. Capital One may not be predatory, but the borrowing National Community wants is lower down on the subprime scale and will create more risk.
Perhaps National Community’s apparently contradictory position can be reconciled by saying that it is distinguishing between good debt to buy a home and bad debt in the form of consumer credit.
The Capital One acquisition is thus really about what type of banking system we want. Do we want a large banking system that has a significant focus on consumer credit? Or do we want smaller banks focused on communities and mortgage lending? And do we want to steer our banks away from certain types of lending?
Dodd-Frank left these questions unanswered. Congress was also unable to decide what it wanted from its banking system, so it kicked the can to the Fed.
In truth, the ING Direct acquisition does not appear to increase Capital One’s systemic risk materially. Capital One will still be a relatively small bank. One could even argue that allowing this midsize bank to get a little bigger might create a real competitor to steal away assets and downsize the banks that are truly way too big, like Bank of America. And many argue that we need big banks in a $14 trillion economy. The real issue is their prudent operation.
As for Capital One’s ability to issue yet more credit cards, this may be a problem, but the government is still grappling with the nation’s addiction to credit cards, as well as the real benefits in the form of credit this lending provides.
This is why the Federal Reserve’s decision on what constitutes a systemically risky acquisition will be so important. Does it extend beyond the size of a bank and its interconnectedness to how the economy works? Because of this issue, Representative Barney Frank, the Massachusetts Democrat, has requested that the Federal Reserve hold public hearings on the matter.
Whether or not a public hearing is necessary, the Federal Reserve should be particularly careful. It needs to put forth a definition that ensures that the banking system is adequately monitored under the current definition for systemic risk. The rules it makes for Capital One could govern the entire banking system going forward. For these rules will naturally extend to other Dodd-Frank provisions that allow the Fed to break up banks that pose a similar threat.
But so far, the Federal Reserve has said almost nothing about how it will apply these rules. This is no way to run a banking system. Whether or not the Fed approves the Capital One/ING Direct transaction, it is time for the Fed to run public hearings on what exactly Dodd-Frank means for our banks and what we as a country want from them.
It has been nearly three years since the banking system nearly collapsed, and we still have not confronted the real banking issues raised by the financial crisis. What type of banks do we really want and need?