Building a lasting off-ramp for strong, sound banks

As Congress and the Trump administration struggle to lighten regulatory burdens across multiple industries, our elected representatives must take care not to inadvertently create a new regulatory regime that shifts these burdens from investors to taxpaying households. 

To reduce the regulatory burden faced by banks, Congress now has the opportunity to build on one of the few pieces of major legislation to move forward in the current session.

{mosads}Earlier this year, the U.S. House of Representatives passed the CHOICE Act, a regulatory reform bill that would give banks an “off-ramp” to escape burdensome prudential regulation and costly stress tests.

To use the off-ramp, a bank would have to maintain a ratio of equity capital to total assets of more than 10 percent, a rate substantially higher than most banks currently maintain. This proposal recognizes that the economic value of equity capital can substitute for costly regulation as a means to discourage banks from taking risks that can lead to their failures or to systemic crises. 

The temptation to take too much risk has too often led to bad behavior. This problem lies behind almost every bank failure and every banking crisis.  

Banks will not take excessive risk if their owners must bear all investment losses. Sufficient equity capital protects bondholders, depositors and taxpayers from losses on bank investments that they cannot effectively control.

Yet, simply requiring a 10-percent capital ratio to avoid regulatory scrutiny is unwise: A conniving manager could take a bank onto the off-ramp and then substantially increase its risk exposure by investing in risky loans and securities. 

If these investments work out, the bank’s owners would pocket the earnings, which could be quite substantial. But if the investments fail, the bank could easily lose more than the value of its equity. Then the bank’s bondholders, the FDIC, and its uninsured depositors would bear the losses, and American taxpayers would lose if the bank is bailed out. 

Entrance to the off-ramp thus cannot depend only on a simple capital ratio. Instead, the required ratio must depend on the risk of the bank’s investments. Banks with riskier investments must have higher capital ratios. 

The calculations that regulators currently use to weigh the risks of bank capital are complex, inaccurate and subject to political manipulation. Regulators could simplify and improve these calculations by basing them on market values and interest rate differentials, thus ensuring that the off-ramp truly provides regulatory simplification.

Large bank failures can impose substantial costs upon other banks and upon the whole economy. To take the off-ramp, systemically important banks (SIBs) should have higher capital ratios than smaller banks. The higher required capital helps protect the economy from the costs that SIB failures can impose upon others. 

After taking the off-ramp, a bank might increase its investment risks or it might realize losses that deplete its equity capital. Either event could lower the bank’s risk-weighted capital ratio below that required for the off-ramp.  

Regulators must require that noncomplying off-ramp banks restore their capital positions by quickly selling new shares. This requirement to recapitalize immediately would help ensure that banks do not take excessive risks. 

As currently written, the CHOICE Act requires that noncompliant banks return to the more costly prudential regulation for at least two years.

The immediate recapitalization requirement is a better way of dealing with the compliance problem, because it ensures that the protection of the financial markets does not depend on regulators who historically have too often given forbearance to politically connected banks. 

Critics of the proposed off-ramp believe that higher capital requirements would impose large costs upon the banks and lead to substantial decreases in bank loans. Such arguments ignore offsetting benefits. Banks with strong balance sheets have lower average capital costs than do those with weak balance sheets. Banks thus lower their average capital costs when they increase their capital ratios. 

Most banks now do not voluntarily increase their equity capital because doing so transfers wealth from stockholders to bondholders and depositors, and ultimately to taxpayers, as new equity makes bonds and deposits more secure and reduces the chance of taxpayer-funded bailouts.  

By decreasing regulatory costs, the off-ramp will provide new incentives to banks to increase their capital ratios.  Lower regulatory costs will increase the funds available to grow American businesses. 

Encouraging banks to have more capital in their financial structures costs the economy less than do banking crises, bailouts and forced liquidations. Adequate capital can provide better protection — for banks and for taxpayers — against failure than can costly prudential regulation. 

Lawrence Harris is a professor at the USC Marshall School of Business, a former chief economist of the SEC and executive director of the Financial Economists Roundtable from whose 2017 policy statement this op-ed was adapted.