October 23, 2017

Beware Bank Lobbying

Stephen Matteo Miller

Senior Research Fellow

Don't let special interests drive reform of financial regulations.

The possibility of reforming the Dodd-Frank Act – Congress' answer to the last banking crisis – has generated a healthy debate. While we should proceed with caution, reforming Dodd-Frank would not necessarily cause another crisis, so long as reforms still require commercial banks to fund themselves with more capital – think of sources of bank funding that aren't prone to bank runs, such as equity and long-term debt – to protect themselves against investment losses, reducing the likelihood of taxpayer bailouts.

Rather than worrying about Dodd-Frank reforms in general, we should worry about special interests discrediting the effectiveness of the so-called "leverage ratio," a simple measure of banks' capital adequacy often defined as equity relative to total assets.

First, some background on why it's important that banks fund with more, rather than less capital. The FDIC stickers you see at your bank signal that the government insures your deposits in case your bank becomes insolvent. A bank with less capital has incentives to overstate the value or understate the risk of what it is doing. When things start to go wrong, investors in the bank's capital experience losses first. So the more capital, the less likely the bank in question will become insolvent.

Successful Dodd-Frank reform means preserving capital requirements like the leverage ratio and avoiding "regulatory capture," a common occurrence in which an industry uses its influence in the regulatory process to satisfy its own interests, rather than the public interest.

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