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May 17, 2012 | Wall Street Journal

Banks Need More Capital, Not More Rules

The J.P. Morgan mistakes that resulted in a loss of $2 billion or more have awakened some senators to the fact that the Dodd-Frank financial-regulation legislation of 2010 did not prevent errors of judgment and investment losses. But the politicians have drawn the wrong conclusion. They claim that more regulation will protect the public. That's wrong for three reasons.

First, J.P. Morgan has more than enough equity capital to cover its losses several times over. Banks' equity capital protects the general public from financial losses much more effectively than regulation. Increasing equity capital means that a bank's stockholders are the ones who absorb the losses that taxpayers were forced to accept in 2008. You won't find that improvement in Dodd-Frank.

In 2008-2009, I advised Sen. David Vitter, the Republican from Louisiana on the Senate Banking Committee, that protecting the public meant we must end the notion that some banks and companies are "too big to fail" and must be bailed out by the taxpayers. Mr. Vitter proposed legislation that required all banks to hold more capital, and large banks to hold proportionally more capital per dollar of assets than smaller banks. Congress quickly dismissed his proposal.

So it's no thanks to Dodd-Frank that J.P. Morgan Chase and other banks hold more capital than they need to. The bankers on the international Basel Committee imposed today's standards. Now Switzerland and Britain want to impose their own new capital requirements, as high as 19% of assets. The Brussels eurocrats oppose the idea. They argue that depositors would choose the safer Swiss and British banks. Unfair to the others! Once again, regulators are protecting banks from competition instead of protecting the public from paying for losses.

Next, consider that regulation is often several steps behind practice. Like other markets, banking markets are dynamic, producing new and different types of risk-bearing instruments. Further, dynamic markets find ways to circumvent regulation. There will be endless argument about whether the instruments J.P. Morgan used are covered by the Volcker rule, a section of Dodd-Frank that restricts a bank's speculative investments.

This debate suggests that regulation is often ambiguous, and none is more so than the Volcker rule, which the regulators themselves have yet to define in detail. Unlike the Volcker rule and other regulations, equity capital requirements are unambiguous and easily monitored in periodic bank examinations or daily inspection of balance sheets.

Third, reducing the risks that commercial banks are allowed to accept raises issues that the proponents of increased regulation never discuss. Where do the risky assets go? To less-regulated entities, like hedge funds or private equity. If a large number of such funds experienced heavy losses, would they be allowed to fail, or would regulators press for a bailout?

The U.S. economy can't grow unless investors are free to finance risky assets. Our future will be much poorer if we convert the banking system into an ever more heavily regulated group of companies.

During America's booms following the Civil War and World War I, commercial banks served as both commercial and investment banks. For safety they held much more capital per dollar of assets. In the 1920s, capital ratios for large New York banks ranged from 15% to 20% of assets. Stockholders took losses, but none of the major New York banks failed during the Great Depression.

Experience shows that regulation is an inadequate substitute for bank capital. Scrutiny failures by the Securities and Exchange Commission left investors in the Madoff and Stanford funds with huge losses. Regulation failed to protect the public. Federal Reserve examiners monitored all the transactions in major banks before the 2008 crisis. These regulators also failed to protect the public and the banks.

Government housing-policy overseers mandated lower down payments and reduced the quality of mortgages, resulting in more than $100 billion in losses at government mortgage lenders. The taxpaying public will pay for the mistakes.

Mr. Vitter had it right; Dodd-Frank has it wrong. Congress should repeal Dodd-Frank and mandate higher capital requirements. Making bankers bear the risks they undertake is the best way to limit those risks.

Mr. Meltzer is professor of political economy at the Tepper School, Carnegie Mellon University and a visiting fellow at the Hoover Institution. His book "Why Capitalism?" was published by Oxford University Press this year.