Hensarling Bill Gives Credence to 'Capital Is King'

Announcing his plan to overhaul the Dodd-Frank Act, House Financial Services Committee Chairman Jeb Hensarling signaled agreement with a growing list of policymakers and scholars who argue that the best way to prevent another financial crisis is to embrace simpler, higher capital requirements rather than other prescriptive regulations that just burden banks and limit economic growth.

The very first section of the Financial CHOICE Act offers banks an "off-ramp" from existing regulatory requirements for those firms meeting a new "well-capitalized" standard. The threshold for obtaining the exemption is a 10% leverage ratio, in which a firm's capital is measured against its assets without any risk weights affecting the calculation.

To be clear, Hensarling is proposing a more rigorous capital standard than any in recent U.S. history. While banks today must comply with a leverage ratio, capital requirements used both by U.S. regulators and in the Basel Committee largely favor risk-based capital ratios, which factored in the recent crisis. Not only does the Hensarling off-ramp cast off the risk-based method, but his proposed leverage ratio is higher than under current regulation.

For example, the U.S. "gold-plated" version of the Basel Committee's non-risk-based leverage ratio for large banks is just 6% (and 5% for holding companies). Hensarling's proposal favors a tougher hurdle, requiring large banks interested in the off-ramp to raise more capital or further simplify their balance sheets. Many community banks, however, would have less trouble meeting the standard if they have not already.

Yet from a broader perspective, the legislation shows a growing realization that stronger capital requirements alone may have been a more effective, and simpler, solution to regulatory reform than the prescriptive regulatory approach implemented by Dodd-Frank.

That line of thinking is echoed in a recent article (co-authored by one of us) arguing that if Dodd-Frank had stopped at sections 606 and 607, which effectively require financial holding companies to maintain "well-capitalized" instead of "adequately capitalized" levels, that might have been a sufficient starting point for reform.

A Richmond Fed study argues that prior to the establishment of the Federal Deposit Insurance Corp., state regulators often used capital requirements, which increased with the size of the local population, as a barrier to entry. As capital requirements began to fall in the late 19^th century, the number of banks in the U.S. ballooned from about 10,000 in 1900 to almost 31,000 in 1921. Many of the new entrants failed over the next decade, and the number of banks declined back to just over 14,000 by the time the FDIC was established.

Moreover, market discipline requires measuring capital at market value, whether capital consists of equity or long-term debt. Unfortunately, the current regulatory capital framework measures capital at book value, which can mask the actual solvency of a financial institution, as bank capital serves more as a balance-sheet entry than a source of funding.

None of this is to say that Hensarling's efforts represent a "silver bullet." If there's one consensus about the U.S. federal financial regulatory regime, it is that it was imperfect both pre- and post-Dodd-Frank. Policymakers will always face challenges trying to prevent "the next crisis" armed only with the knowledge of what "the last crisis" looked like.

It's entirely possible, for instance, that many large, entrenched financial institutions that have already invested significant resources into Dodd-Frank compliance will simply opt to stay within a more familiar regulatory environment. 

But it's nevertheless promising that years of scholarship on bank capital appear to be reaching ready, bipartisan audiences. Higher capital requirements have the potential to move the burden of financing risky banking activities from taxpayers to bank shareholders. Simpler capital requirements help balance the playing field between large firms that can game a complex system and small firms that can compete on customer service but not on regulatory expertise.

Stephen Matteo Miller is a senior research fellow at the Mercatus Center at George Mason University. Chad Reese is the assistant director of outreach for financial policy at the Mercatus Center.