Hi Professor, this is a very useful and interesting post which sheds a lot of light on a complex and important issue. I’d make the following comments:
I’m not sure it is accurate to frame the regulatory developments discretely in terms of Republicans vs Democrats. While Republicans have generally favored a lighter touch regulatory framework, the EGRRCPA was passed with more than 1/3 of Senate Democrats in favor, which these days can be characterized as a bi-partisan initiative! This reflected a concern shared by both parties that regional and smaller banks’ competitiveness was being constrained and that their customers (especially commercial firms, as your article noted) were accordingly being affected. Similarly, it is generally the Democrats who have been the most concerned about the increasing concentration of banking assets - which is the inevitable consequence of more stringent regulations for smaller institutions. (Regulations aren’t the only pressure in this regard - the increasing costs of client-oriented technology, cyber and AML defenses, and other scale-related efficiencies are also a major driver towards consolidation). Therefore while I agree there are some distinctions which can be made, the lines are nuanced and will likely get more so (per below).
The article mentions that there isn’t much evidence of a high correlation between bank capital requirements and their willingness and ability to provide credit. In my experience, there may be times when demand for lending and other credit-intensive services are low, in which case capital requirements aren’t constraining. But there are also plenty of periods when the opposite is true and banks have to carefully allocate their resources. I believe this is the case currently, for example. And as banks’ analytical capabilities become ever more sophisticated, their ability to measure profitable vs unprofitable business opportunities, and so to efficiently price and otherwise allocate resources, also improves - and so too does the capital requirement / lending correlation.
The “Executive Compensation” section of the article discusses adverse alignment of interests in the structure of compensation, which incentivizes excessive risk taking. I agree that there are instances of such misalignment, but in my experience this is generally more the case at an individual banker, desk or even business unit level rather than in the C-Suite or board. In a bank failure, most senior executives lose substantially all of their accumulated value in vested and unvested shares - usually the majority of their net worth - as well as their reputation. They become largely unemployable at least in the regulated financial institution space. The board members also lose their reputations, without (certainly in the case of the independent directors) having significant financial upside. Reflecting this, I think most of the recent bank failures are a consequence of mistakes other than poorly designed senior executive compensation structures (although in certain cases this may contribute as well).
Leaving these nits aside, the article does a great job of framing the fundamental question, which is: “what do legislators, regulators and ultimately voters, want our financial system to look like going forward?” More stringent regulation on smaller banks leading to lower risk of their failure, but also fewer of these banks and higher cost capital to their economically and politically important clientele? Capitalism encourages efficient resource allocation so this will (and already is) leading to expanded non-bank sources of finance and other services - but these alternative credit providers fall outside of existing regulatory frameworks and so introduce their own risks, particularly as the largest players are themselves systemically important. Is this an acceptable trade off? And in the absence of explicit smaller bank support, the largest banks will keep getting larger, with the attendant systemic risk / too big to fail concerns. How do we feel about that?
The most critical components of the regulatory framework - HTM and AFS accounting and the treatment of unrecognized losses in capital ratios, the size of FDIC insurance coverage, the application of capital and liquidity requirements to banks of different sizes, and the role of the unregulated financial institutions in the provision of capital (among others) will depend on the answers to these questions.
Thanks again for a very interesting and informative article!
Hi Professor, this is a very useful and interesting post which sheds a lot of light on a complex and important issue. I’d make the following comments:
I’m not sure it is accurate to frame the regulatory developments discretely in terms of Republicans vs Democrats. While Republicans have generally favored a lighter touch regulatory framework, the EGRRCPA was passed with more than 1/3 of Senate Democrats in favor, which these days can be characterized as a bi-partisan initiative! This reflected a concern shared by both parties that regional and smaller banks’ competitiveness was being constrained and that their customers (especially commercial firms, as your article noted) were accordingly being affected. Similarly, it is generally the Democrats who have been the most concerned about the increasing concentration of banking assets - which is the inevitable consequence of more stringent regulations for smaller institutions. (Regulations aren’t the only pressure in this regard - the increasing costs of client-oriented technology, cyber and AML defenses, and other scale-related efficiencies are also a major driver towards consolidation). Therefore while I agree there are some distinctions which can be made, the lines are nuanced and will likely get more so (per below).
The article mentions that there isn’t much evidence of a high correlation between bank capital requirements and their willingness and ability to provide credit. In my experience, there may be times when demand for lending and other credit-intensive services are low, in which case capital requirements aren’t constraining. But there are also plenty of periods when the opposite is true and banks have to carefully allocate their resources. I believe this is the case currently, for example. And as banks’ analytical capabilities become ever more sophisticated, their ability to measure profitable vs unprofitable business opportunities, and so to efficiently price and otherwise allocate resources, also improves - and so too does the capital requirement / lending correlation.
The “Executive Compensation” section of the article discusses adverse alignment of interests in the structure of compensation, which incentivizes excessive risk taking. I agree that there are instances of such misalignment, but in my experience this is generally more the case at an individual banker, desk or even business unit level rather than in the C-Suite or board. In a bank failure, most senior executives lose substantially all of their accumulated value in vested and unvested shares - usually the majority of their net worth - as well as their reputation. They become largely unemployable at least in the regulated financial institution space. The board members also lose their reputations, without (certainly in the case of the independent directors) having significant financial upside. Reflecting this, I think most of the recent bank failures are a consequence of mistakes other than poorly designed senior executive compensation structures (although in certain cases this may contribute as well).
Leaving these nits aside, the article does a great job of framing the fundamental question, which is: “what do legislators, regulators and ultimately voters, want our financial system to look like going forward?” More stringent regulation on smaller banks leading to lower risk of their failure, but also fewer of these banks and higher cost capital to their economically and politically important clientele? Capitalism encourages efficient resource allocation so this will (and already is) leading to expanded non-bank sources of finance and other services - but these alternative credit providers fall outside of existing regulatory frameworks and so introduce their own risks, particularly as the largest players are themselves systemically important. Is this an acceptable trade off? And in the absence of explicit smaller bank support, the largest banks will keep getting larger, with the attendant systemic risk / too big to fail concerns. How do we feel about that?
The most critical components of the regulatory framework - HTM and AFS accounting and the treatment of unrecognized losses in capital ratios, the size of FDIC insurance coverage, the application of capital and liquidity requirements to banks of different sizes, and the role of the unregulated financial institutions in the provision of capital (among others) will depend on the answers to these questions.
Thanks again for a very interesting and informative article!