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Banking Reform’s Fear Factor

WASHINGTON, DC – Nearly five years after the worst financial crisis since the 1930’s, and three years after the enactment of the Dodd-Frank financial reforms in the United States, one question is on everyone’s mind: Why have we made so little progress?

New rules have been promised, but very few have actually been implemented. There is not yet a “Volcker Rule” (limiting proprietary trading by banks), the rules for derivatives are still a work-in-progress, and money-market funds remain unreformed. Even worse, our biggest banks have become even larger. There is no sign that they have abandoned the incentive structure that encourages excessive risk-taking. And the great distortions from being “too big to fail” loom large over many economies.

There are three possible explanations for what has gone wrong. One is that financial reform is inherently complicated. But, though many technical details need to be fleshed out, some of the world’s smartest people work in the relevant regulatory agencies. They are more than capable of writing and enforcing rules – that is, when this is what they are really asked to do.

The second explanation focuses on conflict among agencies with overlapping jurisdictions, both within and across countries. Again, there is an element of truth to this; but we have also seen a great deal of coordination even on the most complex topics – such as how much equity big banks should have, or how the potential failure of such a firm should be handled.

That leaves the final explanation: those in charge of financial reform really did not want to make rapid progress. In both the US and Europe, government leaders are gripped by one overriding fear: that their economies will slip back into recession – or worse. The big banks play on this fear, arguing that financial reform will cause them to become unprofitable and make them unable to lend, or that there will be some other dire unintended consequence. There has been a veritable avalanche of lobbying on this point, which has resulted in top officials moving slowly, for fear of damaging the economy.

But this is a grave mistake – based on a failure to understand how big banks can damage the economy. Higher equity-capital requirements, for example, require banks to fund themselves with relatively more equity and relatively less debt. This makes them safer, because they are more able to absorb losses, and less likely to become zombie banks (which do not make sensible loans).

The banks claim that higher capital requirements and other regulations will drive up the cost of credit. But there is no sign of any such effect – a point made, rather belatedly, in the Federal Reserve’s monetary policy report to the US Congress last week. On the contrary, the biggest US banks are reporting very healthy profits for the last quarter.

Unfortunately, a big part of these banks’ profits stems from trading securities – exactly the sort of high-risk activity that got them into trouble in the run-up to the 2008 global financial crisis. These are highly leveraged businesses, typically funding their balance sheets with no more than 5% equity (and thus 95% debt).

To understand why this is a problem, consider what happens when you buy a house with just 5% down (or less than 3% down, which is a better analogy for some European banks). If house prices go up, you make a good return on your equity (and a better return than if you had put 20% down). But if house prices go down, your equity may well be wiped out (which is what it means to be underwater on your mortgage).

Higher equity-capital requirements for banks are good for the broader economy – they make financial crises (and the zombie-syndrome) less likely, less severe, or both. US banks are currently funded with more equity than was the case before the financial crisis, and they are doing fine.

Nonetheless, we should still worry about their ability to blow themselves up in a novel and creative fashion – hence the need for the Volcker Rule, derivatives reform, and new rules for money-market funds. And equity-capital requirements for large, systemically important financial institutions remain too low.

The latest indications are that US policymakers are finally starting to focus on this point. Many European banks, however, have less equity than their US counterparts, which creates an important source of vulnerability going forward. If there is to be a broad-based European recovery, the banks must raise more equity, thereby strengthening their ability to absorb potential losses. Unfortunately, there is little sign that European policymakers understand this point.

Instead, senior officials in Europe think and talk like US policymakers did three years ago. They are wary of rocking the financial boat, so they go easy on financial reform and refuse to insist on more equity capital for banks. This is a mistake that they – and possibly all of us – may come to regret.

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