Our failing banks and the capital con game

Press reports suggest that in the wake of the recent flash-panic, big banks may soon be forced by regulators to have 20 percent more capital.

We have seen this story before.

Feckless government fiscal policies create a tidal wave of easy money that camouflages aggressive risk taking while regulators seem oblivious to the financial risks being embedded in the system. Some banks collapse because they had done imprudent things like ignoring the interest rate risk exposure in fixed-rate Treasuries. Others fail because the economy is under duress and they haven’t been nimble enough to stay ahead of borrowers who can’t repay the loans they took out in better times. At the end, the hero — greater capital requirements — rides into town and everyone is relieved.

But if the fix was that easy, why do we always have to endure the failures before we realize the cure? 

We all know it’s not that easy. Stability isn’t about static capital ratios as much as it is about real-time risk management and understanding future economic scenarios. Regulation by ratios just happens to be a lot easier.

When asked about my strategy on bank capital in March of 2017 when I interviewed in the White House to be vice chair of the Federal Reserve Board, I suggested we stop obsessing about it. You can imagine the looks that response received. Big banks were already subject to about two dozen capital ratios and a number of liquidity requirements. Financial ratios had become an all too comfortable but dangerous crutches. I thought that somewhere around 20 capital ratios ago we should have been able to figure out that we were on the wrong path, particularly when it was illiquidity that was the principal cause of many of our largest financial collapses such as Washington Mutual, IndyMac, Lehman Bros. and Bear Stearns.

Nevertheless, we continue to default to increased capital requirements as the elixir of choice after every financial crisis because it seems natural to assume that larger capital cushions will translate into more financial stability. The fact that having to raise more capital also seems to penalize banks and their shareholders is just icing on the cake to some, notwithstanding that the cost of maintaining higher capital requirements is inevitably passed on to consumers in the form of more expensive lending terms and less favorable deposit rates. Offering higher capital requirements alone as the solution is a big con and a dangerous one to the extent that it head fakes people into believing it will do the trick. 

Righting this financial ship starts with rebuilding a nearly100-year-old system of financial oversight that is well past its “sell by” date. Constructed after the Great Depression, it relies on too many federal and state agencies overseeing too narrow a slice of what constitutes financial services these days. The fact that state and federal regulators are continually fighting over turf and even suing each other for it underscores the inefficiency of the system. And despite all these agencies, nearly 100 percent of the country’s prudential regulatory resources are focused on little more than a third of the financial services market: banks. A virtual menagerie of other financial companies ranging from fintech lenders to crypto issuers and exchanges evade most prudential regulation. How does that make any sense?

To get on a path toward greater financial stability, we first must restructure and slim down the regulatory apparatus and then arm it with technological resources that allow it to evaluate data and predict alternative economic trends against which decisions can be made. Just imagine if Google regulated banks. The technological firepower that it would bring to bear would capture and analyze every historical financial, economic and demographic fact necessary to evaluate the health of financial companies and the ecosystem in which they operate. It would run endless algorithms on massive supercomputers measuring and navigating the system toward the most stable and prosperous future scenarios. Nothing close to that happens now.

We also need to rethink financial regulation in a technologically enabled economy and expand our regulatory horizons beyond the “cops ‘n robbers” version that is in place today. It works well for some things, but in a world where the velocity and volume of financial transactions threatens to overwhelm regulatory bandwidths, it constantly leaves regulators behind the curve. Supplementing that system with one that makes both the public and private sectors responsible for collecting, sharing and analyzing real time data will more effectively ensure systemic stability.

Financial stability is a complicated business and sadly there is no one-word solution. So, the next time someone says that one word – capital — will do the trick, be very, very skeptical. That is the best evidence that they may not know what they are talking about. 

Thomas P. Vartanian is the author of “200 Years of American Panics” and “The Unhackable Internet.” He is a former federal bank regulator and currently executive director of the Financial Technology & Cybersecurity Center.