Regulators Finally Start Standing Up to Big Banks

Though the new legislation does arm regulators with more powers that may prevent a large financial institution’s failure from bringing down the broader economy, experts warn these tools are untested, and that the feds may have to resort to bailing out banks again if we suffer a repeat of 2008.

That’s why yesterday federal regulators put forward a proposal that goes beyond Dodd-Frank regulation, as well as the global agreement on minimum banking standards known as Basel III, by asking large banks with more than $700 billion in assets to increase the percentage of their businesses that are funded with equity as opposed to debt.

Lenders do not charge thinly capitalized banks a premium for their risky funding structures because they believe the government will step in if anything goes awry.

Debt is particularly attractive to financiers, however, because it dramatically enhances profit potential on the upside.

Debt is particularly attractive to financiers, however, because it dramatically enhances profit potential on the upside.

Explicit government guarantees like deposit insurance, and implicit guarantees like the financial-crisis bailouts have nearly eliminated the downside of bank borrowing.

Since the 2008 financial crisis, the government has made credible steps towards setting up a system where those bank bailouts won’t be necessary, but we won’t be sure whether those reforms work until the next crisis.

Let’s go back to the home analogy: If your house, which you purchased with $20,000 in cash and $80,000 in debt, increases in value by, say, 5%, you’ve made a tidy 25% profit on your investment.

Explicit government guarantees like deposit insurance, and implicit guarantees like the financial-crisis bailouts have nearly eliminated the downside of bank borrowing.

The reason, as economists Anat Admati and Martin Helwig explained in their recent book The Bankers’ New Clothes, is that government safety nets blunt the riskiness of debt financing.