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More Equity, Less Government: Rethinking Bank Regulation

Thursday, February 24, 2011

What would Milton Friedman and Adam Smith have thought of the Dodd-Frank Act?

History’s two most influential advocates for economic liberty, Adam Smith and Milton Friedman, nevertheless turned away from “free banking” to support some financial regulation and legislative reform in the wake of financial crises. Smith’s views were influenced by the global banking crisis of 1772 and the failure of the Ayr Bank in Scotland. Friedman’s views were shaped by the U.S. banking crisis of 1930–1933, especially the Bank of United States’ failure in 1930.

Yet their proposed reforms would have limited government discretionary power and systemic micromanagement. What would they have concluded from the recent crisis and the policy responses embodied in the Dodd-Frank Act, which expands these powers without addressing the policy failures that largely produced the crisis?

At the core of the recent crisis was the insolvency threat to global banks from large losses in relation to tangible equity capital (total shareholder equity minus preferred stock, goodwill, and other intangibles) from high-risk mortgage backed securities (MBS) that were misrated AAA. The overreliance on credit rating agencies—a legally protected oligopoly—was driven by regulatory policy, which supplanted market discipline.

A more market-based solution would be to simply regulate higher mandated equity standards in the range of 15 to 30 percent of total assets.

The empirical and conceptual flaws in the “measurement” of risk, and the outsourcing of risk evaluation by regulators to the rating agencies have been criticized by financial scholars for more than 20 years. Yet Congress enacted legislation in 2006 that led rating agencies to further relax standards for high-risk MBS.

Likewise, bank equity as low as 2 percent of total assets and leverage for MBS as high as 800 to 1 were made possible by replacing market discipline with the incentives of regulatory capital arbitrage, the political economy of bank regulation, and implicit and explicit government guarantees to bank creditors. Why else would bank equity be so much lower today than a century or more ago, when banks like the City Bank of New York, the predecessor to Citigroup, operated with equity of 30–50 percent of total assets? Why else would bank equity be lower under the 347-page Basel II accord than under the 37-page Basel I agreement?

In light of the deep systemic losses incurred in the most recent crisis—and the poor performance of banks and their regulators in many countries in the last three decades—the assumption that government planning curtails, rather than increases, systemic risk in the financial sector merits skepticism. Relying more on market discipline and required minimum equity would allow for less reliance on short-sighted politicians and fallible regulators to develop, implement, and continually update complex and uncertain systems of regulation.

The overreliance on credit rating agencies—a legally protected oligopoly—was driven by regulatory policy, which supplanted market discipline.

To quote Alan Greenspan: “Adequate capital eliminates the need for an unachievable specificity in regulatory fine tuning.” Had Bear Sterns and Lehman Brothers been operating with tangible equity capital of 15 percent of total assets, for example, neither would have become insolvent. The possibility of a contagion of fear arising from defaults on their debt obligations would have been greatly reduced, as their losses would have been contained within their common shareholders. And higher equity would have reduced the incentives to take excessive risk in the first place.

Recent research by Stanford economist Anat Admati et al. suggests that maintaining higher minimum equity through the control of dividend payouts and new equity issuance is the most powerful, effective, and flexible policy tool for managing systemic risk. She and her colleagues argue that significantly higher equity would bring large social benefits with minimal social costs.

Increased equity would not only reduce the cost of equity to banks but also reduce return on equity, mainly because debt is subsidized through the tax code and government guarantees. One sensible reform is to reduce those subsidies to put debt and equity on a more equal footing. Another is to substantially reduce regulatory costs, which, for depository institutions, may well exceed the cost of corporate income taxes. For example, the bank-affected provisions of the 2001 Patriot Act have not (to the best of our knowledge) led to the conviction of a single terrorist, but in 2003 raised the average labor costs of opening a new account from $7.75 to $22, according to an industry consultant.

The assumption that government central planning curtails, rather than increases, systemic risk in the financial sector merits skepticism.

Reducing federal deposit insurance coverage so that conservative banks could compete better for business, institutional and high-net-worth depositors would discipline bank risk-taking. So would a clear policy rule establishing a ceiling of, say, 50 cents on the dollar in the event government elects to guarantee previously exposed bank liabilities to forestall a future systemic crisis. In keeping with President Obama’s recent recommendations, a comprehensive cost-benefit analysis of all bank regulation, including the Community Reinvestment Act, is also justified.

Supporters of the Dodd-Frank Wall Street Reform and Consumer Protection Act obviously believe expanded regulatory powers offer the best solution to reform, but they should consider that almost all previous major banking legislation has helped to create conditions that inevitably lead to the next banking crisis. A more market-based solution would be to simply regulate higher mandated equity standards in the range of 15 to 30 percent of total assets. In the tradition of Smith and Friedman, this approach would be a much more effective regulatory approach to curbing risk-taking, reducing systemic risk, and preventing a future banking crisis than 2,000 pages of Dodd-Frank.

Mark Perry is a visiting scholar at the American Enterprise Institute and professor of finance and economics at the University of Michigan in Flint. Robert Dell is a commercial real estate banker in Atlanta. They are coauthors of the forthcoming book, Back from Serfdom: A Republican New Deal for Pragmatic Democrats.

FURTHER READING: Perry and Dell previously explained “How Government Failure Caused the Great Recession.” Perry has written “Adding Up the Differences between Boys and Girls,” “Due North: Canada’s Marvelous Mortgage and Banking System,” and “End Dependence on Foreign Oil With Smarter National Policies.” Perry also discussed “The Great Mancession of 2008-2009” and outlined how “EPA's Costly Rules Will Cost Jobs and Set Back Nation's Economic Recovery.”

Image by Rob Green/Bergman Group.

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