The perfect antidote to Dodd-Frank

Published in American Banker.

To overhaul the Dodd-Frank Act, here is a radical and really good idea from House Financial Services Committee Chairman Jeb Hensarling, R-Texas.

The Financial CHOICE Act, Hensarling’s bill, says to U.S. banks: “Don’t like the endless additional regulation imposed on you by the bloated Dodd-Frank Act? Get your equity capital up high enough and you can purge yourself of a lot of the regulatory burden, deadweight cost and bureaucrats’ power grabs – all of which Dodd-Frank called forth.”

This Choice bill, which stands for Creating Hope and Opportunity for Investors, Consumers and Entrepreneurs, is not an order to increase your capital. Rather, it’s offering a logical choice.

Option 1: Put enough of your equity investors’ own money in between your creditors and the risk that other people will have to bail them out if you make big mistakes. And you may. Then, the government can’t claim you live on the taxpayers’ credit, and therefore, can’t justify its inherent urge to micromanage.

Option 2: Don’t get your equity capital up high enough and live with the luxuriant regulation instead. Think of this scenario as the imposed cost of using the taxpayers’ capital instead of your own to support your risks.

Depending on how large the explicit costs and the opportunity costs of the regulation are, you might think that the second option will yield higher returns on equity than option one or you might not. Some banks would choose one option, while some would choose the other.

Different choices would create diversification in the banking sector. They would also create highly useful learning over time. One group would end up sounder and make greater contributions to economic growth and innovation. One group would, over time, prosper more than the other.

Of course, we have to answer: how high is high enough? The 10 percent tangible leverage capital required to get the deal in the proposed legislation is a lot more than now, but is it even enough?

To consider the matter first in principle: surely, there is some level of equity capital at which this trade-off makes sense, some level at which everyone — even habitual lovers of bureaucracy — would agree that the Dodd-Frank burdens would be superfluous, or at least, cause costs far in excess of their benefits.

What capital ratio is exactly right can be, and is, disputed. Because government guarantees, mandates and interventions are so intertwined with today’s banks, there is simply no market answer available. Numerous proposals, based on more or less no data, have been made. The fact that no one knows the exact answer should not, however, stop us from moving in the right direction.

Among various theories, economist and New York Times columnist Paul Krugman proposed a maximum assets-to-capital ratio of 15:1, which means a minimum leverage capital ratio of 6.7 percent. Anat Admati, a Stanford finance professor, and Martin Hellwig, an economics professor at the University of Bonn, argued for a 20 percent to 30 percent leverage capital requirement with no empirical analysis. Economists David Miles, Jing Yang and Gilberto Marcheggiano estimated that the optimal bank capital is about 20 percent of risk-weighted assets, which in their view means 7 percent to 10 percent leverage capital, in a white paper. A group of 20 academics from finance and banking specializations suggested in a letter to the Financial Times a 15 percent leverage capital requirement. Economists Anil Kashyap, Samuel Hanson and Jeremy Stein proposed 12 percent to 15 percent risk-weighted, which means about 6 percent to 8 percent leverage capital. Professor Charles Calomiris suggested 10 percent leverage capital. Economist William Cline estimated the optimal leverage capital ratio at 6.6 percent to 7.9 percent. Robert Jenkins, a member of the financial policy committee at the Bank of England, gave a speech to the Worshipful Company of Actuaries entitled “Let’s Make a Deal,” where the deal was the “rollback of the rule book” in exchange for raising “equity capital to 20 percent of assets.” In my opinion, the 10 percent tangible leverage capital ratio in Hensarling’s bill is a fair stab at it.

In exchange for 10 percent leverage capital, it is essential to understand that the deal is not to eliminate all regulation. Indeed, there would still be plenty of regulation for banks taking the deal. However, option one is a distinctly better choice than the notorious overreaction and overreach of Dodd-Frank. In exchange for a further move to 20 percent leverage capital, one would rationally eliminate a lot more regulation and bureaucratic power.

It’s also essential to understand that the proposed capital ratio as specified in the Hensarling bill subtracts all intangible assets and deferred-tax assets from the allowable capital and adds the balance sheet equivalents of off-balance sheet items to total assets. Thus, it is conservative in both the numerator and denominator of the ratio.

In my judgment, the choice offered to banks by Chairman Hensarling’s proposal makes perfect sense. It goes in the right direction and ought to be enacted. Even the Washington Post editorial board agrees with this. In an op-ed, the editorial board writes:

More promising, and more creative is Mr. Hensarling’s plan to offer relief from some of Dodd-Frank’s more onerous oversight provisions to banks that hold at least 10 percent capital as a buffer against losses…such a cash cushion can offer as much—or more—protection against financial instability as intrusive regulations do, and do so more simply.

Very true!