Plans to swap bank regs for capital hikes could prove costly

Banking deregulation will be a key legislative objective in the next Congress, with Rep. Jeb Hensarling’s (R-Texas) Financial CHOICE Act leading the way.

However, a key premise of financial deregulation — reduced regulatory burden for those banks with less leverage — could have negative unintended consequences for banks, the financial system, and the U.S. economy. 

Leverage is the ratio of the value of a bank’s assets (principally loans and investments the bank owns) divided by equity capital invested in the bank by its stockholders.

A bank can reduce its leverage ratio by financing its assets with a larger portion of equity capital and, correspondingly, less debt in the form of deposits and borrowed funds.

Equity capital provides the all-important cushion to absorb losses arising from uncollectible loans and bad investments a bank has made. That cushion, in turn, protects depositors and other creditors of the bank from suffering any loss. 

If a bank’s equity cushion is wiped out by losses, then the bank will be insolvent, or in banking parlance, it will have failed. 

A lower probability of failure, due to less leverage, justifies reduced regulation intended to prevent insolvency. A lower probability of failure also reduces the risk of loss to the Federal Deposit Insurance Corporation and the amount of premiums it must collect from banks.

However (and this is a critical however), equity capital is more expensive than deposits and other forms of bank debt, such as borrowings in the capital markets.

Since stockholders bear the greatest risk of loss should a bank fail, they demand higher rates of return on their investment in a bank than the rate of interest banks pay on their deposits and other forms of debt. 

Additionally, the tax laws favor debt financing over equity financing, which makes equity capital even more expensive than debt financing, incentivizing banks to increase their leverage, and the likelihood of insolvency.

All other things being equal, higher bank capital requirements will incentivize the capital markets to finance loans and other forms of debt outside regulated banks, in the world of shadow banking. 

That will occur since shadow banking tolerates higher leverage for a given level of risk than do bank regulators. Securitizing subprime home mortgages, instead of a bank holding those mortgages on its balance sheet, is an example of shadow banking. 

The last financial crisis erupted in shadow banking and then quickly infected the highly regulated banks. Worse, shadow banking is much more opaque than the highly regulated banking sector, which means that nasty surprises are much more likely to occur in the former.

Presumably, reducing costly regulation will compensate banks for decreasing their leverage, but that is an as yet untested proposition.

If higher capital requirements are not offset by less costly regulation and/or lower taxes on equity capital, then shadow banking will grow again, after having shrunk in the aftermath of the last financial crisis. Regulated banking will shrivel, setting the United States up for its next financial crisis.

Three important caveats apply to any proposal to reduce bank leverage. First, a bank’s assets and equity capital must be properly valued at all times. 

Losses in asset value reduce the value of a bank’s equity capital, thereby increasing its leverage, which in turn increases its probability of failure. History has repeatedly shown that failed banks overstated the value of their assets because of unrecognized losses.

Second, higher capital requirements (that is, reduced leverage) targeted at the very largest banks must simply be viewed as a technique for forcing the largest banks to downsize. Higher capital requirements will make the largest banks less competitive relative to smaller banks and other channels of financial intermediation. 

Whether the largest banks should be forced to downsize is highly debatable.

Third, higher capital requirements will not eliminate all bank failures. In fact, forcing banks to reduce their leverage by holding more expensive equity capital relative to their assets may have the perverse effect of incentivizing some banks to take more risk in order to pay for that more expensive capital. 

Increased risk increases the probability of failure. As the old saying goes, there is no free lunch. That is especially true in the banking business.

Bert Ely is a principal of Ely & Company, Inc., where he monitors conditions in the banking and thrift industries, monetary policy, the payments system, and the growing federalization of credit risk. 

The views expressed by contributors are their own and not the views of The Hill.