Earlier in the week I criticized the results of Dodd-Frank, because it has miserably failed at its ostensible purpose of preventing future “too big too fail” incidents. Indeed, not only did it not succeed in this–in the sense of reducing the number of potential risks–it has significantly exacerbated it as the banks are increasingly consolidating as larger enterprises as a necessary way to deal with higher regulatory costs.

So, if Dodd-Frank is the wrong solution, what is the right solution?  First, as much as I hate to say it, I’m in favor of some regulation of the banking system.  If we lived in a first-best world, where failures were allowed to go under (and lose only their own capital), I would be an adamant opponent of regulation.  But we don’t live in this world.  What the financial crisis proved to me is that regardless of who is in the oval office when the next financial crisis happens, there will be bailouts.  There is simply too much political pressure by a multitude of interest groups–the taxpayer will be plundered.  In the world of crony capitalism that we have, we will privatize the gains during the good times, and socialize the losses when the crisis hits, because we’ll find ourselves “standing at the edge of the abyss.”

Given this, what can we do to minimize the likelihood of a financial crisis occurring at all?  That seems to me to be the only hope of avoiding bailouts.  Well, first up, and not for discussion this post, is my usual admonition to stop the Federal Reserve from creating more bubbles with its easy money policies.  But you’re probably tired of hearing from me on that–but maybe not from George Selgin over on Free Banking blog yesterday.  Rather I want us to think of a different way of regulation:  regulating incentives rather than regulating behavior.  I look at current regulation attempts (aside from public choice insights about regulatory capture) as a game of whack-a-mole–we tell banks what not to do, and they follow the law (generally) and don’t do it.  But then they go do something else to get around the intended goal of the regulation, which often leads to even worse results. Rather than tell the banks what to do, why not adopt simple regulations that make it in the bank’s own self-interest to do what we would want them to do as a matter of public policy?  Economists would call this incentive compatible policy or regulation.

I’m a big fan of Anat Admati’s book summarized in the video above, and generally agree with her main conclusion:  let’s not tell the banks what they can invest in, or what we think they should do to have acceptable risk, since they are called “systemically important.”  Rather let’s adopt simple, transparent rules that will lead to the correct behavior–so they find it in their own interest not to take too much risk.  So first up is her proposal, which I endorse:  require significantly more capital.  Current regulatory practice is often around 8% capital.  The banks squawk at raising this to say, 10%.  I say, how ’bout 30-40%?  Once its the bank’s money on the line, rather than the taxpayer, their behavior will change.  In her book, Ms. Admati destroys the notion that this will lead to “idle” capital.  In fact, its just another way to finance the assets on a bank’s balance sheet.  Rather than financing their loan portfolio through debt, we can require them to finance through significantly more equity.  In this vein, we could also require double (or more) liability, where the shareholder would be at risk for more than their original investment.  With current limited liability, when a bank gets almost bankrupt (if their loan portfolio’s real worth is close to the bank’s equity), they are incentivized to “roll the dice” with very aggressive practices to try and recover their losses.  When double liability was in effect in the 1800s, banks would almost always shut down once they lost their original investment–they wouldn’t be willing to throw more of their own good money after bad.

So yes to regulation.*  Just simple and transparent:  make them have significantly more of their own skin in the game.  But don’t try and tell them what to do; as long as they have enough of their own funds at risk, they’ll pursue goals that are generally consistent with the public interest.  And don’t listen to the bankers; read Ms. Admati’s book.

* These are not the only possible regulations I would agree with; there may be others worth considering, but the #1 necessity is more skin in the game…significantly more capital.

HT:  Hat Tip on almost all the ideas above to my continuing education on various Econtalk podcasts, where several of the ideas herein have come from.  Russ Roberts has hosted many that deal with the financial crisis.