Will Bank Regulation Hurt Banks In the Long Term?

Regulators and government officials are encouraging even greater limits on banks.

They say that “too big to fail” continues to threaten our economy. Banks need more capital, and should be precluded from investing in risky assets, although regulators and lawmakers don’t even understand the nature of these investments. They object to high compensation, suggesting that large bonuses encourage illegal and improper risk.

There is a huge disconnect between the housing crisis, with all the reforms and proposed legislation being bandied about in Washington, and making banks safer. It was abundantly clear that congressional hearings relating to the financial crisis were witch-hunts that enabled ill-informed and close-minded Congress people to make inane speeches about greed and not allow any rebuttal by financial executives who were flayed at the hearings

Frankly, the assault on banks and related financial companies was part of all-out class warfare that liberal Democrats were waiting to foist on the American public for political gain. It was an opportunity to indict every single commercial banker and investment banker in the country by laying 100% of the blame on them for the financial crisis.

There are serious consequences to making banks smaller, more capitalized, less risky, and less compensated. Most people including our leaders do not understand the full impact banks and investment banks have on our country. Every regulation and restriction is important and will impact the earnings of financial institutions along with their ability to support the economy that ultimately employs Americans.

It would be impossible to review all of the important roles played by financial institutions in this country in this essay. In a nutshell, banks and investment banks facilitate commerce. They provide capital for start-up companies and established companies. They raise money for businesses to grow. They are an essential part of our economy, which is the driving force behind our economic security. The health of this sector is critical. Banks are not enemies of the American people. They not only finance business but also provide mortgages for homes and loans for students, automobiles, and consumer goods.

In a New York Times article, Sheila Bair, a former chairwoman of the Federal Deposit Insurance Corporation said, “I hope the regulators move forward with tough regulations.” [I guess regulation is important to Barr since she used a derivative of the word “regulation” twice in a short sentence.] To this point, Dodd-Frank and Basel III  “are forcing banks to hold safer assets, curtail trading activities and set aside more capital to absorb potential losses.”

The recovery of banks, repayment of their federal loans, and higher profits (a record $39 billion in the first quarter of this year) are not a reason to increase regulation, but just the opposite. Dodd-Frank and Basel III have already addressed a huge chunk of concern. Moreover, most money center banks have scaled back operations to comply with the Volker Rule. Proprietary trading is now a thing of the past in banks. The quid pro quo is that banks lost a huge moneymaker that bank critics say threatened the stability of these institutions. Others say this rule is an hysterical response to the financial crisis.

The article also points out that the experiences of the past few years and the oversight of regulators has resulted in better-managed banks, which should be the real objective.

The current fad is to increase the amount of capital in banks to meet “unforeseen contingencies.” This is a double-edged sword. For sure, highly capitalized banks are inherently less risky and pose less of a threat to the economy. But, they are also inherently less profitable. One must keep in mind that the most expensive form of capital is common equity. If a bank wants to extend a loan to a corporation, it is exponentially cheaper to borrow from the commercial paper market than to issue new stock to fund the loan.

Moreover, if a bank is required to hold more government securities, as opposed to other investments, its “capital” is bolstered but it will earn far less on a Treasury security than a loan.

It should be noted that balancing the debt and equity ratio in a company is an art. It is a function of risk and tolerance for risk. Bank managers are the most proficient at achieving the right balance to ensure profitability without endangering their companies.

For sure regulators must participate in this delicate balance of risk and reward. But if the target is “too big to fail,” regulations and capital requirements will hurt bank profits and their ability to raise more capital to fund American commerce.

“Too big to fail” is a reality that this country must live with. The history of bank failures has had only a negligible impact on the economy in the past century.