Auburn professor: Raising bank capital requirement may hold key to heading off future crises

After a housing boom and bust triggered a broader financial crisis in 2008 and, eventually, the Great Recession, American lawmakers responded in familiar fashion.

They passed legislation.

In this case, the Dodd-Frank Wall Street Reform and Consumer Protection Act was signed into law and described by the president as essential in ensuring citizens will "never again" be subjected to another devastating financial crisis.

These words are quite familiar to Auburn University Finance Professor James Barth and George Mason University Senior Research Fellow Stephen Miller, who examined banking laws and banking crises over more than 100 years. As uncertainty swirls around the future of the Dodd-Frank Act, the co-authors examined whether simply increasing the bank capital requirement from the current 4 percent to 15 percent would bring greater stability to the banking industry in the years ahead.

"Every time we've had a banking crisis, the president at the time will sign into law new legislation and say 'never again will we have another banking crisis,'" said Barth, Lowder Eminent Scholar in Finance in Auburn University's Raymond J. Harbert College of Business. "Maybe instead of 20 years or so we'll wait 30 years to have another banking crisis. That's our history. We don't pass laws to prevent a crisis. We pass laws in response to a crisis."

Congress passed the Dodd-Frank Act in 2010 in response to the most recent crisis, which was fueled by a housing boom and bust. The subsequent recession cost Americans $19.2 trillion in wealth and 8.8 million jobs. President Trump's recent efforts to chip away at financial regulations enacted during the Obama administration raises as the following questions: What's next for the Dodd-Frank Act? In particular, what will follow if it is repealed or dramatically altered? And will any reforms that are implemented eliminate the likelihood of future banking crises?

Barth and Miller outline one such needed reform in a recent research paper, "Benefits and costs of a higher bank leverage ratio," released by George Mason University's Mercatus Center. The co-authors examine U.S. banking regulations and banking data from 1892 to 2014 to assess whether the benefits exceed the costs of increasing the simple capital-to-asset leverage ratio for banks from 4 percent to 15 percent.

"We believe the best way to create a more stable and safer banking industry is to require the owners of banks to put more of their own capital at risk," said Barth, co-author of the 2012 book "Guardians of Finance: Making Regulators Work for Us (MIT Press)." "That is to say that if a bank has $100 in assets, we're basically proposing that the owners should have $15 of their own money at risk. There's more skin in the game. This should moderate the owner's proclivity towards risk because they will be the ones who lose money if they engage in excessively risk activities rather than having the taxpayers be on the hook and bailing out banks that get into serious trouble, as recently happened."

The authors calculate and compare the benefits and costs of increasing bank capital requirements from 4 percent to 15 percent, based on 256 different sets of assumptions, and find that the benefits equal or exceed the costs in nearly every case.

In their examination, Barth and Miller found that laws passed to prevent crises address past problems and may have unintended consequences that invite future systemic failures. In the case of the Dodd-Frank Act, which sought to "promote the financial stability of the United States by improving accountability and transparency in the financial system" and protect taxpayers by ending bailouts and the concept of "too big to fail," major banks absorbed billions in restructuring costs and added thousands of compliance staff positions. A 2014 Wall Street Journal report detailed the cost of Dodd-Frank compliance, showing that expenses for Wall Street firms climbed 10 percent from 2009 to 2013 while revenues for that same period declined 10 percent.

"I'm not so sure Dodd-Frank will be repealed in its entirety," said Barth, also a Milken Institute senior fellow who has testified before congressional committees and served as an appointee of the Reagan and George H.W. Bush administrations. "I think the major concern of the Dodd-Frank Act is that it imposes a lot of costs on banks while not also adding to their revenues. Moreover, I don't think Dodd-Frank is effective in addressing the so-called 'too big to fail' issue. We have some very big banks and they have gotten bigger in recent years, and that's a cause for concern if indeed they do get into trouble again."

Barth said Dodd-Frank compliance has been particularly nettlesome for community banks, which typically feature smaller staffs and may possess fewer revenue streams than their Wall Street-based counterparts. "Banks, especially the smaller banks, have to hire additional people who are costly but yet aren't really in the business of generating revenue by making loans or taking in deposits," Barth said. "That's a cost that has to be passed on to the consumers in the form of higher interest rates on loans."