Answering the multitrillion-dollar question on bank regulation

Treasury Secretary Steven Mnuchin and many others argue that the regulatory response to the 2008 financial crisis in the form of the Dodd-Frank Act has burdened banks with costly regulations that slow growth and hurt American workers.

What set of policies might the Trump administration promote to enhance efficiency without exposing the economy to another crisis?

{mosads}Both before the 2008 crisis and still today, incentives for excessive risk-taking are baked into the compensation schemes of bank executives. Most large financial institutions reward executives with bonuses if stock prices rise, but executives never pay a penalty, “a negative bonus,” if things go badly.

These compensation schemes encourage executives to invest in excessively risky endeavors that can generate large spikes in stock prices, even if these investments expose the institution to bankruptcy and the economy to ruin.

In theory, private markets should act as a bulwark against these perverse incentives. Depositors, bondholders and shareholders should have incentives to monitor managers and adjust compensation schemes because they have money at risk.

As a practical matter, however, expectations that the government will rescue “too-big-to- fail” (TBTF) institutions have eroded the incentives of investors to constrain risk-taking by executives.

Recent regulatory actions intensified these TBTF expectations. When regulators rescued banks during the 2008 crisis, depositors and bondholders typically experienced no losses, and shareholders were partially protected.

The Federal Reserve not only bailed out investors in the major commercial banks, it also provided assistance to major investment banks and a large insurance company.

Although people continue to argue about the efficacy of these bailouts, there is little dispute that they taught investors that the Fed would print as much money as necessary to save any institution perceived to threaten financial stability.

It is therefore easy to see the logic behind the policies imposed after the 2008 crisis. With TBTF expectations reducing monitoring by the market, regulators become the primary bulwark against excessive risk.

What will happen if the Trump administration removes these regulations without addressing the underlying incentives for excessive risk-taking? The good times will roll for a while, but once the gambles fail, a new financial crisis will follow.

How can America reduce growth-reducing regulations without exposing the economy to another crisis? At first glance, the answer is obvious: Since TBTF expectations encourage reckless risk-taking, get rid of those expectations.

Congress might limit the ability of the Fed and Treasury to bail out financial institutions. The problem with this approach is that it is not credible. Since the 1980s, investors have watched the government bail out one financial institution after another. They have learned that no politician wants to be held responsible for “the end of the world.”

A related approach to TBTF expectations is to impose size limits on banks so that they are “small-enough-to-fail.” This, too, is problematic. In the first place, it puts the government in charge of deciding the “right” size of private enterprises.

In the second place, the high degree of interconnectedness among financial institutions means that the failure of institutions of even modest size can threaten the stability of the entire system.

Many experts recommend increasing bank capital requirements. A larger capital buffer will shift more losses on to bank shareholders in the event of insolvency. But, it will not necessarily fix the incentive problem.

When regulations boost capital, this does not imply that banks will have large shareholders with lots of “skin-in-the- game,” who therefore have the power and incentives to constrain risk-taking.

Rather, banks tend to raise additional equity from diffuse shareholders or from funds with diffuse investors. Under these conditions, increasing capital requirements will not reduce the excessive risk-taking incentives generated by TBTF. 

Another way to address the incentives problem is to regulate the compensation schemes of executives. The goal of this approach is not to reduce compensation. Rather, it is to eliminate incentives for excessive risk-taking.

For example, there might be limits on the proportion of executive pay tied to risk-inducing bonuses; or, bonuses might be paid into an account that is only distributed to executives over time, as evidence emerges that they contributed to the long-run prosperity of the financial institution and not just a short-run, bonus-creating spike in stock prices. 

A major criticism levied at regulating compensation is that it interferes in private markets. This argument only holds, however, if TBTF does not create perverse incentives for excessive risk-taking. We are, unfortunately, already in the TBTF world. 

This time can be different. If the incentives of investors and executives are properly aligned, then loosening regulations that inhibit the flow of capital to promising enterprises will foster growth without triggering a financial crisis.

If, however, the Trump administration loosens the shackles but does not address the incentive problem, then we may see a repeat of 2008.

Stephen Haber is A.A. and Jeanne Welch Milligan professor in the School of Humanities and Sciences and Peter and Helen Bing senior fellow of the Hoover Institution at Stanford University. 

Ross Levine is the Willis H. Booth chair in banking and finance at the Haas School of Business at the University of California Berkeley.