By Alex J. Pollock.Invasive regs, like Dodd-Frank, will stifle industry.Editor's note: The following is an edited version of the testimony of Alex J. Pollock before the House Committee on Financial Services on July 12 — the week before the sixth anniversary of the Dodd-Frank Act — on regulatory reform proposed in the Financial CHOICE Act. .Detailed intrusive regulation is doomed to fail. This is the considered, and in my view correct, conclusion of a prominent expert in bank regulation, Sir Howard Davies, former chairman of the U.K. Financial Services Authority and former director of the London School of Economics. Detailed, intrusive regulation is what we've got, and under the Dodd-Frank Act, ever more of it.."Financial markets cannot be directly 'controlled' by public authorities except at unsustainable cost," Davies adds. Surely there is a better way to proceed than promoting unfettered bureaucratic agencies trying through onerous regulation to do something at which they are doomed to fail..The lack of sufficient capital in banks is a permanent and irresistible temptation to governments to pursue intrusive micro-regulation which becomes micro-management. In a world in which governments explicitly and implicitly guarantee bank creditors, the government in effect is supplying risk capital to the banks which do not have enough of their own. Suppose the real requirement were for an equity capital ratio of 8 percent of assets, but the bank has only 4 percent. If the government implicitly provides the other 4 percent — or half the required capital — we should not be surprised when, for example, the 50-percent-shareholder demands a significant say about how the bank is run, even if the resulting detailed regulations will not be successful..However, the greater the equity capital is, the less rationale there is for detailed regulation. In our example, if the bank's own capital were 8 percent, the government's effective equity stake would be down to zero. This suggests a fundamental and sensible trade-off: more capital, reduced intrusive regulation. Want to run with less capital? You get intrusive regulation..In other words, give U.S. banks the following choice: If you don't like the endless additional regulation imposed on you by the bloated Dodd-Frank Act, well, get your equity capital up high enough and you can purge yourself of a lot of the regulatory burden..The Financial CHOICE Act offers a very logical decision to make between two options:.Option One: Put enough of your equity investors' own money in between your creditors and the risk that other people will have to bail the creditors out if you make mistakes. Mistakes are inevitable, the bank's defense is equity capital: have enough so that the government cannot claim you are living on the taxpayers' credit, and therefore cannot justify its inherent urge to micro-manage..Option Two: Don't get your equity capital up high enough and instead live with the luxuriant regulation of Dodd-Frank. This regulation is the imposed cost of using the taxpayers' capital instead of your own to support your risks. I believe the choice thus offered in the proposed act is a truly good idea..Making the choice, banks would have to consider their cost of capital versus the explicit costs and the opportunity costs of the regulatory burden. I think the group with more capital, operating in relatively freer markets with greater market discipline, would prove more successful..We have to determine how much capital is enough. What capital ratio is exactly right can be, and is, disputed. We are not looking for a capital level which would remove all regulation—only the notorious over-reaction and over-reach of Dodd-Frank. For Option One, the CHOICE Act requires 10 percent tangible capital to qualify, the bank also must have one of the best two CAMELS ratings..In my judgment, the proposed choice between Option One and Option Two makes perfect sense. It definitely takes us in the right direction and ought to be enacted..Alex J. Pollock served as president/CEO of the Federal Home Loan Bank of Chicago from 1991 to 2004. He is a resident fellow of the American Enterprise Institute in Washington D.C.
