The financial system needs more capital and less complexity

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Have we learnt anything from the great financial crisis of 2008? Or any number of banking crises that came before or since, right up to the collapse of Silicon Valley Bank and others last year? Sometimes I think not.

To me, the core lesson is that too much debt and leverage, combined with too little high-quality capital on hand, always ends in tears. And yet, as the massive lobbying by US banks pushing back against the Fed’s attempt to implement Basel III rules shows, we are still arguing about the basics of what makes the financial system safer.

Industry executives and lobbyists say, as they always do, that holding more capital against risk will make them less profitable, and thus crimp lending (despite plenty of evidence that it hasn’t thus far). They are also arguing that it will push risk into shadow banking instead. Finally, they complain that the current proposed rules are far too complex.

On the latter point, I agree — 1,087 pages is a lot of text. What large institutions don’t say is that their own lobbying efforts are in part responsible for that complexity, as they’ve pushed for tweaks and hedges to rules. They are also in the best position to navigate the regulatory framework, as their legions of lawyers will inevitably find the profit-enabling loopholes. It will just cost everyone more in the process.

But the other arguments don’t hold water. Of course risk has moved into the far less well-regulated non-bank sector post 2008. That’s not an argument for lighter regulation in formal banking, particularly with debt levels in both the public and private sector at near record highs. It’s an argument for more regulation of shadow banking. We need a race to the top, not the bottom, if we are to create a safer financial system.

The more troubling and, quite frankly, cynical argument, is that asking large banks to hold more capital will hurt vulnerable individuals, impacting mortgage lending to minorities, for example. Let’s start with the fact, pointed out by Americans for Financial Reform, that 70 per cent of the mortgage market (and the vast majority of loans to minorities) is government-backed and wouldn’t fall under the new rules. Plus, non-banks make far more loans to black and Latino families, albeit with higher fees (which is a topic regulators should pursue).

Despite this, Fed vice-chair of supervision Michael Barr is under tremendous pressure to water down the capital rules for big banks, in part because Wall Street has managed to bring together a bunch of liberal Democrats and racial justice groups who have bought into their argument. 

It’s a clever lobbying approach, and one with historical precedents. In the late 1970s, Citibank chief executive Walter Wriston wanted to overturn Regulation Q, a Depression-era banking rule that limited the amount of interest banks could offer to savers, as a way of preventing them from moving into risky investments to pay those high-yield deposits. 

He brought not only financial institutions but consumer activist Ralph Nader, along with the “Gray Panthers”, a series of multigenerational advocacy networks, into his coalition. They understandably wanted to help small-time savers. But while the eventual rollback of Regulation Q raised deposit rates, it also opened up a Pandora’s box of interest rate risk. Banks made bigger profits, but the move didn’t help in the cases of steelworkers or schoolteachers with a fluctuating rate on a 35-year mortgage that could now shift in unpredictable ways.

My point here isn’t that we should bring back 1930s banking era regulation wholesale. It’s that we should remember the basics. The financial system is better for ordinary people when it’s simple and boring. We’ve been moving away from that paradigm since the 1970s, and it’s a problem that only gets harder to fix. Whenever we are at the end of a major economic cycle, nobody wants to lose access to easy money. In the run-up to 2008, for example, there were plenty of progressives arguing for looser monetary policy and easier lending standards for weaker borrowers.

Their hearts may be in the right place. Yet the problem — which was quantified by academics Amir Sufi and Atif Mian in their seminal book House of Debt — is that this approach amounts to playing by the rules of a game that never work for the little guy. More credit is good for finance — debt is the lifeblood of Wall Street. But the financial crisis was an “extinction-level event” for black wealth, as former congressman Brad Miller once put it. When the subprime crisis hit, the most vulnerable borrowers lost in two ways: first, with disproportionate wealth destruction, and second because, like all taxpayers, they had to foot the bill for the clean-up.

The next crisis, whenever it is, won’t look like the last one. That’s another argument that banks use to push against Basel III. That’s likely true, but again, it’s not an argument for allowing more risk in the formal financial system, but rather one for less risk elsewhere.

I’m with Minneapolis Fed president Neel Kashkari when he says that “instead of doubling down on a complex system of rules for banks that provide the illusion of stability, we should adopt a far simpler and more effective solution: more equity capital”. Let’s stop fighting the obvious, and focus on getting more capital into a simpler financial system.  

rana.foroohar@ft.com