A buffer against bailouts

The main regulatory skirmish in Washington these days pits the new Republican majority, which wants to roll back the 2010 financial reforms known as the Dodd-Frank Act, against Democrats and the president, who vow to protect every jot and tittle.

The Dodd-Frank Act isn’t casual reading: It started out as a 2,319 page law, and bank regulators have added thousands of pages of regulations in the five years since it was passed.

The overall objective of the law isn’t hard to understand. When giant financial institutions like Bear Stearns and AIG collapsed in 2008, bank regulators spent hundreds of billions of dollars bailing them out. The new law was designed to make the biggest banks safer and to give regulators better tools for shutting down a bank if it nevertheless fails.

It’s hard to argue with safer big banks, but the new law tries to achieve this objective by setting up a European-style partnership between the government and the banks. J.P. Morgan, Citigroup, and the other giants are permitted to dominate the banking business as long as they accept greater regulatory oversight and satisfy the government’s political demands.

The big losers are small and medium-sized community banks—the banks that actually lend money to most American businesses. Because community banks will not receive bailouts if they fail, they cannot easily compete with the giant banks. And many of the new regulatory requirements apply to all financial institutions, not just the biggest ones. Because the giant banks already have extensive compliance departments, they can bear the new regulatory burden much more easily.

Many of the amendments lawmakers have proposed in Washington recently are designed to ease the burden on community banks and to give them a fighting chance. Some would be no-brainers in an ordinary political environment, but have encountered resistance due to Democrats’ fear they are a Trojan horse that Republicans could use to bring the whole regulatory colossus down.

I personally would favor breaking up the biggest banks, which would eliminate “too big to fail” bailouts and make it possible to roll back a great deal of the new legislation. But it’s hard politically to imagine the enactment of legislation that would level the playing field between big banks and community banks.

Even if breaking up is too hard to do, there may be ways to rely less on regulators to keep the biggest banks in check. Why not reward a bank with regulatory relief if it makes itself safer?

The main safety technique is higher capital requirements, which serve as a buffer against financial distress. The largest banks now are expected to hold roughly 12.5 percent capital, much more than before the 2008 crisis. This is similar to a family that pays 12.5 percent in cash for their house and finances the other 87.5 percent with a mortgage.

A 12.5 percent buffer isn’t bad; but just as we now know that housing values can drop more than 12.5 percent in a crisis, it is not hard to imagine a bank losing 12.5 percent of its value and turning to the government for help. If a bank had twice as much capital, by contrast, only a truly massive crisis would generate pressure for a bailout.

J.P. Morgan or Citigroup would never set aside this big a buffer on their own. But suppose Congress promised to exempt any bank that maintained 25 percent capital from all (or almost all) of the new regulation. A group of banking scholars (including me) called the Shadow Financial Regulatory Committee has just made a proposal along these lines. The proposal would rely on the banks themselves, not regulators, to reduce the need for future bailouts. Regulators might not like the proposal, but the prospect of less regulation and safer banks should be attractive to everyone else.