Are Regulations Making American Banks Safer? Or More Risky?

The more I study the banks, the more convinced I become that a lot of the regulations passed to make the banking system “safer” have created the exact opposite result. One thing that’s not very well understood in political and media circles is that very few big American banks were in danger of becoming truly economically “insolvent” during the financial crisis. I’ve heard some claims that every bank was “insolvent”, but I’d contest that: rather, every bank was perceived to be insolvent due to American regulations that dramatically overstate risk. The reason America has more banking crises than many other nations is because America has the strictest banking regulations.

We’ve heard repeatedly that the Canadian banks are safer than their American counterparts, but this largely based on perception created from looser capital requirements, which make Canada’s banks look “better capitalized” on paper. If the Canadian banks were required to live by the same standards as the American banks (or vice-verse), the American banks would be considered much safer.

Take for example, the Royal Bank of Canada. RBC’s Tier 1 capital ratio is 13.3% and this is one of the primary ways we assess risks in the banking system. Meanwhile, Tier 1 capital ratio at Bank of America is slightly lower at 12.89%. Based on this, Royal Bank of Canada looks better capitalized. But if we take a look at leverage, we see a radically different story.

RBC’s ratio of Tangible Common Equity to Total Assets is about 3.6%, while Bank of America’s is 6.6%. This would suggest that Bank of America is significantly less leveraged than RBC. Leverage, of course, isn’t the only determinant of risk, since some assets are riskier than others. However, it’s probably a reasonable claim that RBC and BofA have similar asset profiles in their portfolios.

RBC is considered “safer” merely because of Canadian regulations. It’s safer because Canadian banking regulations say it’s “safer”. Yet, economically speaking, it would appear that Bank of America is safer. It’s just that BofA faces greater regulatory risks as a result of American banking standards.

This brings up the disturbing point that it’s not economic realities fueling perceptions of bank solvency. Rather, regulations actually re-shape the way we think about this issue. Too tight regulations actually cause banks to become insolvent, because they are perceived to be “insolvent” under the regulations.

This ultimately shows how our 80 year experiment with tight banking regulations has largely backfired. The banks haven’t become economically safer as a result of the regulations. Rather, they’ve merely adapted to the regulations so that they are perceived to be “safer”. But what happens when the regulations create a misstatement of risk?

I’m certainly not opposed to all banking regulations, but I think the system we’ve created here in the US is largely responsible for our frequent banking crises. It should be dramatically scaled back and simplified, with a focus on total leverage as measured via tangible common equity to total (tangible) assets.

For instance, require banks to hold TCE of at least 8% of the total asset base; and if they dip below this figure, give them two years to re-comply. But let’s quit this song and dance on Tier 1 capital, which is a completely arbitrary measure of risk that varies dramatically from nation to nation.