More fundamentally, given the broad array of activities and risks that take place within the banking system, government regulation alone will not arrive at the appropriate levels of capital. So what justification then exists for the post-crisis surge in mandated bank capital as compared to more reliance on market forces?
First, some argue that mandatory requirements are necessary to prevent overexposure between large financial institutions that could result in a chain reaction of failures. But effective supervision of risk management policies and procedures, together with prudential limits on counterparty exposures, can prevent this.
Second, some argue that government-mandated bank capital requirements are necessary to protect the financial system against an asset-price "shock" that could render a major portion of the banking system insolvent.
But it is important to remember that, in 2008, most banks were in trouble not just because of real estate-related losses but also because of the contagious run on the entire financial system. And many large banks were clearly solvent, including JPMorgan, Wells Fargo, State Street and Bank of New York Mellon.
Third, some argue that our modern society is too dependent on large banks to permit any of these institutions to fail. But large banks can generally continue to function in reorganization. What regulators need to do is make sure that banks can still perform their critical functions, like payments and clearing and settlement, in bankruptcy.
However, the fourth reason for government-mandated capital requirements is valid: the market demands too little capital because bank creditors, due to government bailouts, are not fully at risk for losses.
In principle, this rationale for capital requirements can be eliminated by allowing banking organizations of any size to fail and imposing losses on their creditors. Indeed, Title II of Dodd-Frank was created precisely for this reason.
However, regulators are seeking to implement Title II in such a way as to ensure that the creditors of bank and broker-dealer subsidiaries will never lose money in bankruptcy. This is accomplished by requiring bank holding companies to hold huge amounts of long term debt that can be converted to equity and then used to protect subsidiaries against losses.
The regulators were legitimately worried that imposing losses on the short-term creditors of these subsidiaries could trigger a contagious panic across the financial system. But this will not work. Even a doubling or tripling of existing bank-capital requirements, plus TLAC, would be insufficient to enable banks or broker-dealers to withstand a run. Capital would be quickly exhausted by the need to liquidate assets at fire-sale prices.
So what is the best path forward for the Trump administration?
First, the administration must make it clear that all insolvent banks will be allowed to fail and losses will be imposed on creditors of the entire banking organization based on normal priorities. This is different than the existing resolution regime that attempts to ensure that the creditors of banks and broker-dealers will never incur losses.
Second, in order to allow large banks to fail without subjecting the financial system to a panic, the administration must support the Federal Reserve as a strong lender of last resort to solvent financial institutions.
A solvency determination is not easy but broad public guidelines can be devised to frame such a determination. There is no moral hazard created by the Fed lending to a financial institution that is the victim of an irrational run. And long experience has shown that this is the only effective way to stop a financial panic.
Third, these changes would permit an appropriate lowering of government-mandated bank capital requirements. Market forces would do a better job of setting bank capital requirements, because the expectation of a government bailout would have been eliminated.
The new administration could therefore achieve: 1) a resolution system that puts bank creditors at risk 2) a lender of last resort that protects the otherwise solvent financial system from a panic and 3) higher economic growth from a more market-based approach to setting bank capital requirements.
Commentary by Hal S. Scott, a professor at Harvard Law School and the director of the Committee on Capital-Markets Regulation. He is also the author of the law-school textbook "International Finance: Transactions, Policy and Regulation" and "Connectedness and Contagion: Protecting the Financial System from Panics." Follow him on Twitter @HalScott_HLS.
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