The United States is approaching the seventh anniversary of the passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Though the act was intended to limit risk taking by banks and promote financial stability, many economists and politicians think instead that it’s an example of regulatory overreach that has hamstrung large institutions, squashed smaller ones, and pushed the US toward a sclerotic, uncompetitive, and crony-ridden financial industry—one that is no safer from systemic crisis than it was before.

Republican Jeb Hensarling, chairman of the House Financial Services Committee, has introduced the Financial CHOICE Act to reform Dodd-Frank. The core of the act is simple: large banks should fund themselves with more capital and less debt. In that way, losses are borne by shareholders, not taxpayers. Furthermore, losses do not spread to other financial institutions through runs or debts unpaid, so the government does not have to try to regulate risk taking in great detail.

The act strives for a very simple measure of capital adequacy in place of complex Basel rules, by using a simple leverage ratio. Very roughly, banks should fund themselves with more than 10 percent equity relative to the value of their assets.

And the act has a clever carrot in place of the stick: this is not a regulatory requirement. Instead, banks with enough capital are exempt from a swath of Dodd-Frank regulation. Banks can operate with less capital if they want, but the Dodd-Frank regulators will be back.

In November, Hensarling solicited “advice and counsel” on modifications to his bill, and that invitation, along with the increased likelihood of regulatory changes under a new president, is a good prompt for a discussion of what regulatory reform should look like.

Find market-based alternatives to a leverage ratio

The most important question, I think, is how, and whether, to improve on the leverage ratio with a better but similarly simple and transparent measure of capital adequacy. Keep in mind, the purpose is not to determine a minimum capital level at which a bank is resolved, closed down, bailed out, etc. The purpose is to find a minimal capital ratio at which a bank is so systemically safe that it can be exempt from a lot of regulation.

There is always a trade-off between simplicity, transparency, and accuracy. So, one can complain about inaccuracies of the leverage ratio. For example, it means that banks must have $10 of equity to take $90 of your money and buy $100 of reserves at the Fed—the safest investment imaginable. It also gives banks incentives to invest in riskier securities. A $10 call option and a $100 stock can have the same risk, but the call option requires only $1 of equity, not $10.

The “right” answer remains, in my view, the pure one: 100 percent equity plus long-term debt to fund risky investments, and short-term liabilities such as deposits must be entirely backed by treasuries or reserves. But, though I still think it’s eminently practical, it’s not on the current agenda, so for the time being let’s return to the task of coming up with something better than a leverage ratio.

Market values. First, we should use the market value of equity, not the book value, to measure a bank’s capital position.

The market value of equity (and debt) is a better measure of the value of bank assets than are accounting measures, or even mark-to-market values. Asset risk weights are complicated and open to games, and no asset-by-asset system captures correlations between assets. Value at risk captures that correlation, but people trust the correlations in those models even less than they trust risk weights. Accounting values pretend assets are worth more than they really are, except when accounting values force marks to market that are illiquid or “temporarily impaired.” The market value of equity solves these problems neatly. If the assets are unfairly marked to market, equity analysts know that and assign a higher value to the equity. If assets are negatively correlated so the sum is worth more than the parts, equity analysts know that and assign a higher value to the equity.

Liabilities, not assets. Second, we should use the ratios of liability values, not the ratios of equity and debt to asset values. Rather than measure a ratio of (book) equity to (accounting) asset values, look at the ratio of market value of equity to the debt that the bank issues. Here, I would divide market value of equity by the face value of debt, and especially debt under one year. We want to know if the bank can pay off its creditors, or if there will be a run.

So far, then, I think the following ratio:

market value of equity / (equity + face value of debt)

is both better and much simpler than the leverage ratio that compares book value of equity to complex book value of assets.

One can do even better:

(market value of equity + 1/2 market value of long-term unsecured debt ) / market value of short-term debt

is attractive, as the main danger is a run on short-term debt.

Use options prices for tails. Ratios such as these are, I think, an improvement on leverage ratios all around. But both measures have a common problem, and I think we can improve them both.

A leverage (equity/assets) ratio doesn’t distinguish between the riskiness of the assets. As above, a bank facing a leverage constraint has an incentive to take on more risk. (A deep problem of accounting is that measuring the value of something does not tell you how likely that value is to change.)

The main motivation of risk weights is to try to measure assets’ risk—not the current value, but the chance of a big loss in value—and make sure there is enough equity around for all but the worst risks. You can see why critics want to bring back risk weights.

So let’s try to solve the risk problem with market prices.

A simple idea: use options prices to measure the banks’ riskiness. An option gives you the right to buy or sell a stock at a given price. The more volatile the stock, the more valuable the option. So options prices tell you the market’s best guess of the chance that stocks can take a big fall. You can use options prices to calculate “implied volatility,” a measure of the standard deviation of stock returns.

Our regulators’ and bankers’ strong preference for accounting values rather than market values comes from the fact that they think they know values better than markets do.

If Bank A has bought stock worth $100, and Bank B has call options that are worth the same $100 but are 10 times riskier, the options prices on Bank B’s stock will be much larger, and therefore the implied stock volatility will be higher.

So, bottom line: use the implied volatility of bank options to measure the riskiness of the bank’s assets. Don’t ignore risk (leverage ratio) or try to measure it with complex risk weights (Basel).

As a simple example, suppose a bank has $10 market value of equity, $90 market value of debt, and 25 percent implied volatility of equity. The 25 percent implied volatility of equity means 2.5 percent implied volatility of total assets, so (very roughly) the bank is four standard deviations away from wiping out its equity.

We might be able to simplify even further. As a bank issues more equity and less debt, the equity gets safer and safer, stock volatility goes down, and the implied volatility of options goes down. Perhaps it is enough for regulators to say, “The implied volatility of your at-the-money options shall be no more than 10 percent.”

There are even purer versions of the same idea, though one has to think a bit harder about options markets to see how they work. A put option is the right to sell stock at a given price. So determine the minimum cost of put options that give the bank the right to issue stock at a price sufficient to cover its short-term debt. For example, if the bank has $1,000 of short-term debt, then we could look at the value of 10 put options, each giving the bank the right to sell its stock at $100. If the market value of equity is greater than the cost of this set of put options, the bank is OK.

In short, I think we could improve a lot on the current leverage ratio by using market values of equity, using ratios of equity and debt liabilities rather than accounting asset values, and using options prices to measure risk.

Our first step is to get our regulators and bankers to trust the basics:

  1. Stock markets provide good measures of total value—at least better than regulators.
  2. Options markets provide good measures of risk—at least better than regulators.

What if market gyrations drive down the value of a bank’s stock? Well, that would be an important signal that bank management and regulators should take seriously! The bank should have issued a lot more equity to start with to make sure that didn’t happen. It should have issued contingent convertibles or bought put options if it thought raising equity was hard. And when a bank’s equity takes a tumble, that is a great time to send the regulators in to see what happened.

Fundamentally, our regulators’ and bankers’ strong preference for accounting values rather than market values comes from the fact that they think they know values better than markets do. (A cynic might also add that accounting numbers are easier to fudge.) Markets get it wrong all the time—but accountants, bankers, and regulators get it wrong much more often!

We can live with a leverage ratio

The problems with a leverage ratio are not catastrophic. Right now, banks have to issue capital if they take your money and hold reserves at the Fed or hold short-term Treasury debt. That obviously doesn’t make much sense, as those are riskless activities, and banks are complaining.

More subtly, a leverage ratio forces banks to issue capital against activities that are almost as safe, such as repurchase (“repo”) lending secured by Treasuries. Stanford’s Darrell Duffie argues that the leverage ratio discourages banks from acting as intermediaries in the markets for safe assets such as repo loans.

The natural response, then, is to start risk weighting lite. The Bank of England recently exempted government securities from their leverage ratio. But consider the natural response to the natural response: once we start making exceptions, the lobbyists swarm in for more. The poster child for the ills of risk-weighted asset regulation: Greek sovereign debt still carries no risk weight in Europe.

Are markets illiquid? Are there people who can’t get loans? The answer, usually forgotten in policy, is not to prod existing businesses to change, but to allow new ones to enter.

But how much damage is really done by asking for capital for safe investments? Recall the Modigliani-Miller theorem after all: if a bank issues equity to fund risk-free investments, the equity is pretty darn risk free too, and carries a low cost of capital. And even if funneling money to safe investments costs, say, an extra percent, does that really justify the whole Dodd-Frank mess?

In the end, it is not written in stone that large, systemic, too-big-to-fail banks must provide intermediation to safe investments. A money-market fund can take your deposits and turn them into reserves, needing no equity at all. There are many other ways to funnel risk-free money to risk-free lending activities. The usual mistake in financial policy is to presume that the current big banks must always remain, and must always keep the same scope of their current activities—and that new banks, or new institutions, cannot arise when profitable businesses such as intermediation open up.

So, in the worst case that a leverage ratio makes it too expensive for banks to funnel deposits to reserves, or to fund market making or repo lending, then all of those activities can move outside of big, too big to fail, banks.

Let Dodd-Frank wither

The CHOICE Act has some additional interesting characteristics.

Most of all, it offers the carrot I mentioned earlier: banks with sufficient equity are exempt from a swath of regulation.

That carrot is clever. We don’t have to repeal and replace Dodd-Frank in its entirety, and we don’t have to force the big banks to utterly restructure things overnight. Want to go on hugely leveraged? The regulators will be back in Monday morning. Would you rather be free to do things as you see fit and not spend all week filling out forms? Then stop whining, issue some equity, or cut dividends for a while.

More deeply, it offers a path for new financial institutions to enter and compete. Compliance costs and a compliance department are not only a drag on existing businesses, they are a huge barrier to entry. Are markets illiquid? Are there people who can’t get loans? The answer, usually forgotten in policy, is not to prod existing businesses to change, but to allow new ones to enter. A new pathway—lots of capital in return for less asset-risk regulation—will allow that to happen.

In the Department of Finish Sanding, I would suggest requiring a good deal more than 10 percent equity, and I would also prefer a stair step: 10 percent buys exemption from X (maybe SIFI—systemically important financial institution—status), 20 percent buys exemption from Y, and so forth, until at maybe 80 percent equity plus long-term debt you’re not even a “bank” any more.

Remember, the issue is runs, not failure. Banks should fail, equity be wiped out, and long-term debt become equity. The point of regulation is not to make sure banks are “safe” and “don’t fail.” The point of regulation is to stop runs and crises. So ratios that emphasize short-term debt are the most important ones.

Ultimately one of the act’s cleverest provisions is that it doesn’t obliterate Dodd-Frank, but rather provides a route around it. Both politically and economically, it is much easier to let Dodd-Frank die on the vine than to uproot and replant it.

John H. Cochrane is distinguished senior fellow at Chicago Booth and a senior fellow of the Hoover Institution at Stanford University. This essay is adapted from a post on The Grumpy Economist blog.

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