Washington, July 11, 2016 -

Wall Street Journal Editorial
July 10, 2016

House Republicans are rolling out their 2017 agenda, and one promising idea is Financial Services Chairman Jeb Hensarling’s plan for financial rules that promote economic growth and protect taxpayers.

Don’t believe the shrieks that this is about “rolling back” financial reform to let the banks run wild. The financial system was heavily regulated before the 2008 panic; regulators failed to do their job (see Citigroup) and missed signals from the housing market, among other mistakes. The Dodd-Frank Act of 2010 doubled down on the same approach: Give even more power to regulators with the promise they’ll be smarter the next time.

History tells us that is a fantasy. Regulators will focus on solving the previous problem, while they miss where the excesses are really building. As Charles Kindleberger taught, the essence of a credit mania is that everyone follows everyone else and thinks it will never end. Regulators are no better than bankers. As late as March 2008, then New York Fed President Tim Geithner was telling his colleagues on the Open Market Committee that banks were in good shape.

Mr. Hensarling has a better idea, which is to let banks build much higher equity-capital cushions to protect against the next mania and panic. Now, as before the crisis, regulators pretend that giant banks have abundant resources to absorb losses by allowing them to report a bogus “Tier 1 risk-based capital ratio.”

With a complicated process subject to intense lobbying, regulators undercount exposures they deem to be safe—the way they designated mortgage-backed securities rock-solid before the last panic. This allows well-connected bankers to convince Washington that their favorite assets should have low “risk weights.” Regulators can politically allocate credit by favoring some types of lending over others.

The Texas Congressman wants a simpler system in which private investors with money at risk decide which assets are safe. Under the Hensarling plan, banks can opt out of today’s complicated rules if they have capital equal to 10% of their assets. Their tally of assets has to include off-balance-sheet exposures. No more hiding toxic paper in conduits or structured-investment vehicles as Mr. Geithner allowed Citi to do before the financial crisis. And no more pretending that a financial instrument has no risk because a regulator says so.

Capital at the largest banks today often runs below 7% of assets. The Wall Street giants would have to raise a lot more equity—and therefore pose less danger to the public—to get regulatory relief. They thus may not like the Hensarling plan, which is fine. Smaller competitors willing to operate without a taxpayer safety net deserve the advantage of lower regulatory costs.

One reason the 2008 panic was so severe is that the government had encouraged all financial institutions to invest in the same stuff. When housing declined, they were all in trouble. Dodd-Frank is encouraging the same mistakes. Witness the recent insanity of Washington forcing Wells Fargo to issue more debt so it can look more like the Wall Street giants at the heart of the government’s regulatory model.

The Hensarling plan would make the financial system more stable by encouraging greater diversity. Freed to make their own decisions on the quality of assets, some banks would run off the rails, but they are less likely to make the same mistake at the same time.

Mr. Hensarling goes further in shrinking the safety net by kicking non-banks out of the too-big-to-fail club. This means no more taxpayer-backed derivatives trading, a Dodd-Frank innovation that has given Wall Street’s giant clearinghouses access to emergency loans from the Federal Reserve.

Whether a Wall Street giant is a bank or not, the creditors of its subsidiaries should no longer be protected by Dodd-Frank’s political “resolution” process. Mr. Hensarling aims to create a special bankruptcy court for large financial companies with experienced judges and the resources to act quickly—but these resources will not include a taxpayer bailout.

The promise of the Hensarling plan is more safety for taxpayers and a banking system that supports a growing economy. One reason Dodd-Frank has never delivered the economic boost that President Obama promised in 2010 is that Washington’s distorting role in the flow of credit was dramatically increased.

In this era of hyper-regulation, David Malpass of Encima Global notes that banks have been making relatively few loans to small and mid-size companies while extending huge credit to large corporations and government. A slow-growth economy that doesn’t efficiently allocate credit isn’t safe for anyone.

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