The recent financial crisis resulted in passage of several new regulatory and policy safeguards to improve the stability and safety of banks – but have they gone far enough? It is certainly an arguable proposition.
The Federal Deposit Insurance Corporation (FDIC) has done its part through several measures, one of which is the permanent raising of bank deposit insurance to $250,000 per depositor from the original $100,000 prior to the 2008 crisis. The limit had been scheduled to revert back to $100,000, but the Dodd-Frank legislation canceled this reversion.
This helps somewhat, but it doesn't address what got the banks in trouble in the first place – risk, including incorrect assessment or representation of risk, and poor management of it when properly assessed.
You may think of the bank with the stereotypical vault and Scrooge McDuck swimming around in huge piles of cash, but the assets of banks are distributed through many different financial vehicles – including investments.
The Volcker Rule, part of the Dodd-Frank legislation, is targeted at addressing the risks that banks are taking with these investments. Meanwhile, a separate byproduct of Dodd-Frank was enacted by Federal regulators in an April meeting, requiring banks to keep more money in reserve.
Both of these actions help, but let's look at them individually – first with the reserve issue.
Banks are required to keep a minimum amount of capital in reserve to absorb unusual losses and to mitigate risks. That amount, known as the leverage ratio, is determined as a percentage of the assets the bank holds. The recent ruling raised the required leverage ratio for larger banks (assets greater than $700 billion) to 5% (up from approximately 3%) and to 6% at FDIC-covered subsidiaries.
Banks naturally resist larger capital cushions, because it reduces overall return on their equity. Just like you, the more banks have to keep on hand for a rainy-day fund, the less there is available for investments with a greater return.
A proposed alteration of this rule, scheduled to take effect in 2018, will be causing a massive fight in the coming years. Instead of being able to set leverage ratios based on the risk of the assets, the alteration would require the leverage ratios to be set regardless of risk – a straight capital-to-asset ratio. U.S. banks may have to hold an extra $68 billion to comply, according to estimates by regulators. This is likely to force banks towards more conservative investments – and lower profits.
A few weeks ago, Federal Reserve Governor Daniel Tarullo gave a speech where he in essence suggested that it is hard to trust banks to judge their own risk exposure. He may be right because of the above logic – banks have incentive to underestimate risk in order to keep less mandated capital on hand. Enter the Volcker Rule as another form of control.
The Volcker Rule prohibits banks from trading -- or acquiring an ownership interest -- in various forms of risky securities, derivatives, and other instruments. The intent is that any activity in this field cannot be used to increase a bank's profits, with regulations and requirements scaled based on the size of the bank. However, the rule is not at all straightforward, with exceptions and arguable definitions. Experts disagree on its interpretation.
The Volcker Rule took effect on April 1st, with full compliance mandated by July 2015.
Currently, it is one big battle between regulators saying, "You can't be trusted to manage your own risk, the temptations are too great" and banks saying, "You don't understand the consequences of your actions." Probably both are right.
So in the end, have regulations contributed to keeping American banks safe? Banks are certainly safer than they were, but the forces toward banks creeping back toward higher risk/higher return activities are natural and powerful – and the rules are, as always, subject to negotiation and change. Unless we return to the days of the Glass-Steagall Act (which prevailed from 1933 through 1999) with its clear separation of commercial and investment banking activity, we will be forever struggling to find the proper balance.
Keep the faith in banks, but watch their financial actions. We are reminded of Ronald Reagan's famous words regarding the Soviet Union – "Trust, but verify."
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