Bank Reform: Goodbye Dodd-Frank or more of the same?

The Senate is working on bank reform. Under Dodd-Frank Act, banks are required to meet certain capital requirements and regulatory requirements if their assets total more than $50 billion. The propose change applies those capital and regulatory requirements only to banks that have assets totaling more than $250 billion or foreign banks with global assets totaling more than $100 billion.

Lately, I've been spending my evenings reading Walter Bagehot's Lombard Street. It is a very insightful book, which is of some relevance to the topic on hand. In the book, Bagehot claims that if it weren't government intervention or interference, banks would keep larger capital reserves.

Banks, he explains, have an incentive to lend as much money as possible. If they don't they give up making any interest on it. Banks only keep enough money on hand for handling day-to-day operations. They also keep a reserve fund, which is used try and keep a bank's doors open during a run. In Bagehot's day, most smaller banks deposited their reserve funds with the Bank of England. Today most banks deposit their reserve funds with the Federal Reserve.

Capital requirements are something different. A bank trades with both its own money, raised from shareholders, but also with borrowed money, raised from lenders. Why? Because it allows banks to increase their profits. Take a hypothetical. Arch-Con Banking Corps, knows a lender that will give it money at 5%. It also knows another a borrower that will give it 8% for money. Arch-Con borrows the money. Re-lends it. Everything works out. Arch-Con pockets 3%.

Not a bad way to make a bit of money. A capital requirement, however, is a requirement like, for every $1 raised from shareholders, you may only borrow $10. Needless to say, as a hypothetical bank, I'm not keen on such an idea. Why? Well for a start, I don't think government has any place telling me I can't borrow as much money as I damn well please.

Secondly, it's not like money raised from shareholders is free. I have to pay a dividend on it. Take Lloyds, a bank I happily owned shares in until Gordon Brown cornered our chairmen at a drinks party and talked him into being patriotic. It pays its shareholders a dividend of 4.54%. But if I want to borrow the same amount of money, I only have to pay the LIBOR, which for one year is currently, 2.5%.

Let's look at the example above. I have two "lenders" one lends at 2.5% one lends at 4.54%. I have a borrower that will pay 8%. Obviously, because I want to maximize profits, I want to use the lender that gives me money at 2.5%, not 4.54%, The government forces me, however, to use a certain amount of money from my shareholders.

If the deal goes a little south, my shareholders lose out. If the deal goes really south, my shareholders and lenders still lose out.

All this is window dressing, however, if the government is too afraid to let banks fail. And banks can still fail. All it takes is for banks to get creative about risk, for regulators to grow numb and not notice this creativity, and they'll be off to the races.

If you want good banks, you have to let bad banks fail.