On July 21, 2010, President Barack Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act, aimed at ensuring the financial system would never again bring the U.S. to the brink of economic disaster. Five years later, the job remains far from done.
Consider, for example, the law’s impact on bank capital, a crucial element in protecting the economy from financial shocks. Also known as equity, this is the money provided to institutions by their shareholders. Unlike most types of debt, it doesn’t have to be paid back — a feature that allows bank to absorb losses and keep lending in bad times. The government had to rescue banks during the 2008 crisis because the cushion was insufficient.
To some extent, regulators have used their powers under Dodd-Frank to require more capital. As of Dec. 31, the six largest U.S. banks had, on average, about $5 in equity for every $100 in assets (calculated according to international accounting standards). All else equal, that’s enough to absorb a 5 percent loss on assets, up from less than 4 percent in June 2012.
Problem is, the increased buffer remains dangerously thin. Even a hint that banks would come close to exhausting their equity could freeze the financial system — and losses can easily approach 5 percent. Back in 2009, when U.S. banks were still struggling to recover from the crisis, the International Monetary Fund estimated that their losses would amount to more than 8 percent of all the loans and securities they held.
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Given the size of some banks, the dollar amounts involved can be significant. Using information from stock markets, economists at New York University built a model that estimates how much capital banks would need to avoid distress in a severe crisis. As of July 10, their analysis suggested that only one of the largest six U.S. banks, Wells Fargo, had enough. The other five had a total shortfall of $137 billion.
If big U.S. banks’ finances are so precarious, how can they function? The answer is that creditors expect the government to step in and rescue the institutions if they get into trouble. This “too-big-to-fail” status allows the banks to borrow more cheaply than their inadequate capital cushions would otherwise allow — an implicit subsidy that benefits their executives and shareholders. Judging from recent research by economists at the New York Federal Reserve, the subsidy has so far survived Dodd-Frank’s efforts to eradicate it.
The law’s anniversary will undoubtedly elicit calls to roll back financial regulation. In some cases, such as community banking, changes would make sense. In core areas such as bank capital, however, regulators still have a long way to go. If equity requirements were raised enough to eliminate implicit subsidies to the biggest banks, shareholders would have a greater incentive to break them up into more manageable — and more valuable — businesses. Perhaps then, regulation could be made simpler, too.