After eight years of our economy bumping along — even with the lowest interest rates in our nation’s history — we believe it’s worth asking whether the Federal Reserve and other regulators are driving with their right foot on the monetary policy accelerator and their left foot on the regulatory policy brake.
In particular, if we’re looking to explain subpar business growth, we might turn our attention to how regulation is changing the role of banks in our economy.
It is worth remembering what banks do. At their core, they engage in what’s called maturity transformation: they take short-term deposits from individuals and businesses and convert them to long-term assets – commonly, loans. Holding short-term liabilities and making long-term loans carries significant liquidity risk – the risk that depositors will want their funds back before borrowers repay – and interest rate risk – the risk that rates paid on deposits will rise before rates earned on loans. On the other hand, this maturity transformation provides extraordinary benefits for the economy, as it allows savers to fund indirectly the growth of businesses that they would never lend to directly.
To understand the tradeoff, consider Bank A, which engages in complete maturity transformation, and Bank B, which engages in none. Bank A lends every dollar deposited to creditworthy businesses, but is doomed to fail, either in the event that depositors want their money back unexpectedly, or in the event that interest rates rise sharply. Bank B, on the other hand, takes deposits and purchases short-term government securities. Bank B can meet any depositor redemption, and its assets will always reprice along with its liabilities. But it won’t do anything to foster economic growth; indeed, it won’t really be what we think of as a bank. Borrowers will instead turn to non-bank lenders who necessarily charge much higher rates for loans, because their own cost of funding is much higher and variable.
The effect of almost every post-crisis regulation has been to push U.S. banks to be more like Bank B. Our nation’s banks hold far more short-term, liquid assets than they did pre-crisis, in place of the kind of loans to businesses and families that would generate economic growth. Companies seeking lines of credit face diminished availability and increased price because regulations force banks to assume that those lines will be drawn in amounts greater than in the recent financial crisis, requiring banks to hold cash to fund those hypothetical conditions.
The story on capital is much the same as on liquidity. Capital requirements limit the amount of maturity transformation a bank can perform for each dollar of its equity. Our economy has reached a tipping point, where regulatory capital requirements have become so high that banks must assess the viability of each line of business by how much it increases regulatory capital. Banks are leaving profitable lines of business – for example, holding mortgages where the borrower is anything but a perfect credit — because the regulatory capital charges are based on historically unprecedented loss rates.
A similar equation is playing out in capital markets. U.S. companies can issue debt at lower rates than they can borrow from banks because investors know that they have the option of selling the obligation. Bank-affiliated dealers facilitate those sales by standing ready to buy or sell at a posted price at any time. Again, though, holding securities inventory involves risk, and post-crisis regulation has dramatically increased the cost of holding, funding and even hedging that inventory. For example, the regulatory leverage ratio requirement now requires the largest U.S. banks to hold over $50 billion in capital against cash held on reserve at the Federal Reserve. That is $50 billion that could be deployed to support America’s businesses, but is now held to protect against loss on the least risky asset in the world.
Of course, we learned in the crisis that capital and liquidity levels needed to rise in the banking system, and many of regulatory changes in recent years have been wholly appropriate. Capital levels needed to rise, and reliance on short-term funding needed to fall. Make no mistake: safe and sound regulatory policy and rigorous economic growth aren’t mutually exclusive. But eight years post-crisis, with the U.S. banking system more resilient than ever, U.S. regulators are continuing to increase both capital and liquidity requirements, and thus far have shown no interest in revisiting existing rules.
Furthermore, regulation continues to focus myopically on the risks of banks– oddly, given that the worst moments of the crisis all focused on non-banks (money market funds, AIG, Lehman, Fannie Mae). Perhaps one reason for this myopia is that most of the regulations affecting U.S. economic growth originate in the international Basel Committee on Banking Supervision – not reforms in the Dodd-Frank Act.
Thus far we’ve only noted the regulations that are written down, but below the water line, examiners now are ever more aggressive in telling banks what loans to make – and too often not to make. Currently bank examiners are telling banks to restrict loans to leveraged companies (very broadly defined), restrict commercial loans, and restrict multi-family housing loans.
While we obviously are concerned about the imbalance here, we are even more concerned about the failure of many policymakers even to acknowledge that a balance is necessary. Surprisingly, policymakers in Europe and Asia now have no such reservations. The Bank of England recently lowered capital requirements to stimulate lending. And with economies struggling even more than ours, European and Asian finance ministries are imploring bank regulators not to raise capital and liquidity requirements even further. But U.S. regulators have signaled plans to do just the opposite.
Indeed, in a clever marketing move, U.S. regulators have coined the phrase “gold plating” to describe the imposition on U.S. banks of rules more onerous than international standards. But King Midas teaches us a good lesson about the limits of gold plating, and the financial crisis has taught us a more recent lesson about relying on non-banks to do the work of banks. And perhaps the pace of economic growth is teaching us yet another.
Mr. Nichols is President of the American Bankers Association, and Mr. Baer is President of the Clearing House Association.
The views expressed by Contributors are their own and are not the views of The Hill.