In a speech Tuesday, Hensarling introduced a blueprint for rewriting the 2010 Dodd-Frank Act. The Financial Choice Act includes plenty of bad ideas -- such as killing an initiative to improve financial data and ending special oversight of systemically important institutions -- but it should be applauded for a very good one: Relax the rules for banks that maintain a higher level of capital.
As Hensarling notes, equity capital from shareholders is not “money put under a mattress.” It’s cash that banks lend out or otherwise put to work. Unlike most kinds of bank liability, however, it automatically absorbs losses -- which makes the whole system more resilient. The more banks rely on capital rather than deposits or other debt, the more they can safely lend even in bad times, and the less regulators need worry that a bank’s mistakes might tank the economy.
Hensarling proposes that any bank with at least $1 in equity for each $10 in assets -- a 10 percent leverage ratio -- should be freed from most other regulations, including rules aimed at ensuring that they have enough easy-to-sell assets on hand to survive a panic. That’s too adventurous. Research and experience suggest that more equity than this is needed to avoid distress in a severe crisis. And even a well-capitalized bank can fail if, for example, it lacks the liquidity to pay creditors on time.
A better approach would be to start with community banks, which Dodd-Frank has hit especially hard. For institutions with no significant trading or derivatives operations, a 10 percent leverage ratio would justify a lighter examination schedule, a lot more freedom in mortgage lending, and an exemption from complex reporting on the riskiness of assets. Such a deal -- which Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corporation, has proposed -- could revitalize a crucial part of the financial system without compromising safety.
For larger banks, many of the current rules implicitly offer a similar trade-off: The more capital a bank has, for example, the easier it is to pass stress tests and write so-called “living wills.” But this could go further. Well-capitalized institutions, for example, don’t need micromanaging by examiners -- a practice that anyway does little to prevent catastrophic errors, as the “London Whale” fiasco demonstrated.
Simpler oversight in return for greater financial strength. Hensarling is right: That makes a lot of sense.
The opinions expressed here do not necessarily reflect those of the MPA editorial board.
In his efforts to dismantle the financial reforms of the past six years, Republican Congressman Jeb Hensarling makes an excellent point: Regulation could be a lot less burdensome if banks had enough capital.