Baker Institute expert: More financial regulation ‘not always better’

While some degree of regulation can help improve financial stability, complex and overlapping regulations can actually cause banks to increase their risk-taking activities, according to an expert in the Center for Public Finance at Rice University’s Baker Institute for Public Policy.

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Thomas Hogan, a fellow in public finance at the Baker Institute, outlined his insights in a new issue brief, “Strong, Simple Regulations Promote Financial Stability.”

“One of the most important and counterintuitive ideas in financial regulation is that more regulation is not always better,” Hogan wrote.

U.S. bank regulators have recently proposed two reforms related to complexity. First, the Board of Governors of the Federal Reserve System (the Fed) has introduced a proposal that would simplify bank capital regulations. Second, the Fed and the Office of the Comptroller of the Currency (OCC) have proposed reducing large banks’ capital requirement, known as the enhanced supplementary leverage ratio (eSLR), which would push the financial regulatory system toward greater complexity, Hogan said.

His brief summarizes the debate over regulatory complexity, outlines the current proposals from the Fed and the OCC and recommends reforms to help improve financial stability.

“Banks in the United States are subject to a wide variety of regulations, the scope and scale of which have drastically increased since the 2008 financial crisis,” Hogan wrote. “While some regulations may be effective at reducing bank risk, complex regulations can actually increase risk in several ways. For instance, overlapping rules can push banks to take risks that were not expected by the regulators. Complexity also creates loopholes that allow banks to take even greater risks. Finally, if regulators do not properly understand the riskiness of different assets, they can unintentionally encourage risky investments.”

The main criticism of the eSLR modification proposal is that it will increase bank risk by reducing required levels of capital, Hogan said. “The Fed and the OCC estimate a modest reduction of $400 million in global systemically important banks’ total capital requirements that, they argue, could spur bank lending. The FDIC, on the other hand, estimates a capital decrease of $121 billion, which could have substantial effects on bank risk,” he wrote. “Contrary to the Fed and the OCC’s claims, most academic research on optimal capital ratios finds that higher capital requirements would help stabilize the financial system with few adverse effects on lending. Some studies find that higher capital requirements since the financial crisis are associated with lower bank lending, but it is difficult to know if such effects were caused specifically by capital requirements or by other regulations, such as restrictions on mortgage lending. Studies that compare the costs of lower lending to the benefits of increased stability often find that capital should optimally be much higher than the current levels, possibly in the range of 15 to 20 percent of total assets, rather than the current average of about 11 percent.”

A second — but equally important — criticism of the proposal to lower the eSLR is that the risk-based capital ratio rather than a leverage ratio would become the main determinant of bank behavior, Hogan said.

“For example, Randal Quarles, vice chairman for supervision at the Fed, recently testified before the U.S. Senate Committee on Banking, Housing and Urban Affairs that simple leverage requirements can encourage banks to take excessive risks,” Hogan wrote. “As a banker constrained by a leverage ratio, he argued, ‘you will bear the same capital cost if you take on a very risky asset versus if you take on a less risky asset.’ While Quarles is correct that simple leverage ratios assign equal weights to assets of different risk levels, he overlooks the fact that an incorrectly specified risk-based capital rule can actually put less weight on risky assets, as was the case with mortgage-backed securities prior to the financial crisis.”

Hogan said actions by the Fed and the OCC could help improve U.S. financial regulations and reduce the probability of another financial crisis.

“The Fed should adopt its proposal to simplify bank capital regulations by integrating its stress-testing program with its regulatory capital rules,” he wrote. “It should consider further ways to reduce regulatory complexity in order to minimize risk in the banking system. The Fed and the OCC should abandon their proposed modifications to the eSLR and instead make greater use of simple leverage ratios as binding constraints on bank capital. Future proposals should consider raising — not lowering — bank capital requirements, since higher levels of capital are likely to improve financial stability with only minor effects on bank lending.”

About Jeff Falk

Jeff Falk is associate director of national media relations in Rice University's Office of Public Affairs.