A Step Backward in Financial Regulation

Now, we welcome the Choice Act's recognition that adequate equity financing of financial institutions is crucial to limiting crises. But we fear that the level sought by the act — a 10% ratio of equity financing to the institution's assets — is too low for the few truly systemic institutions. Further, that ratio is wholly insensitive to the riskiness of the institutions' assets. And by cutting back on stress tests that gauge large institutions' ability to weather a financial crisis, the act would make them and the broader financial system less robust to unexpected shocks.

Further, the act would limit federal regulators' abilities to deal effectively with large institutions if they did get into financial difficulties, since the act would eliminate the institutions' living wills (documents that provide a road map for an orderly shutdown) and the temporary financing needed to prevent creditor runs during the process of resolution.

The Choice Act also worsens one of Dodd-Frank's key faults: the propensity to regulate by legal form rather than economic function. For example, the Choice Act largely ignores the possibility that non-banks engaged in bank-like activities could be a source of systemic risk. But recall that in 2008 those five large investment banks mentioned above were beyond the purview of bank regulation and were considered well-capitalized by their supervisor, the Securities and Exchange Commission. Similarly, Fannie Mae and Freddie Mac were giant mortgage securitizers that were outside the bank regulatory system. And today the money-market mutual fund industry — which needed federal guarantees to halt a run during the financial crisis — still doesn't get proper oversight.

Finally, the Choice Act places additional limitations on the Federal Reserve's ability to deal with any future financial crisis and imposes constraints on its wider role in setting monetary policy. Although the central bank must be held accountable, we believe that the act restricts the Fed in ways that would reduce the independence and effectiveness of monetary policy and circumscribe its role as lender of last resort.

To be sure, we support the Choice Act's slashing of burdensome regulation. For example, the Volcker Rule, which bars a bank from making risky trades for its own account with depositors' money, is far too complex and costly given its limited impact on systemic risk. Similarly, regulators can safely reduce the compliance costs imposed on most banks, which do not pose systemic risk, if they have adequate equity financing.

Nevertheless, the current version of the Choice Act would be a major step backward: It would make our financial system less safe than Dodd-Frank. There is still time for the House of Representatives to make changes that would promote safety and efficiency. We hope they do.