Newswise — The delicate balance between a free banking system and its political regulation appears to be at equilibrium amid the current financial landscape. Yet little more than a decade ago, as a result of the banking crisis, regulations such as the 2010 Dodd-Frank Act forced the largest banks to maintain mandatory capital on hand, avoiding the risky loan ratios that brought economies to a teetering point. In the aftermath of this regulation, big banking has regained its footing — and when banks are profitable, politicians exert more regulatory influence on them to make politically favored loans, a new paper suggests.

Wherever the United States economy is headed next, a Washington University in St. Louis finance and regulations scientist has published a paper with a theoretical model that basically proposes bridging the divide between bankers and politicians to link such capital requirements to something of a political football: credit allocation — a bank’s business of financing loans.

“It’s an unsettled debate,” said Anjan Thakor, the John B. Simon Professor of Finance in Olin Business School. “Regulatory and legislative credit allocation directives happen to be the white elephant in the room that nobody wants to talk about. But they exist in all countries, including the U.S.

“In this paper, I do not take a stand on whether they are good or bad, but that they need to be linked to prudential regulation of the affected banks,” he said. “There is no explicit link at present between these regulations — credit allocation and prudential bank regulation are done in two different silos in the United States. My point is that there needs to be an explicit link between credit allocation and capital requirements.”

So Thakor posed his theory in strings of computational propositions in a paper published online, ahead of print, on April 7 by the Journal of Financial Intermediation, “Politics, Credit Allocation and Bank Capital Requirements.”

Going back generations, regulation such as the Community Reinvestment Act of 1977 attempted to bring universal homeownership, allocating credit to middle- and lower-income communities. Its intention was to overcome discrimination such as redlining or refusing certain groups loans or mortgages. However, these regulations inadvertently resulted in riskier lending by banks. Loans went belly up. So did banks. The damage done could have been contained if lawmakers had adopted more stringent prudential regulation.

No countries connect capital requirements with credit allocation, and banks long have complained about higher capital requirements being burdensome. So it is a double whammy: Capital requirements are reduced when credit allocation regulation is imposed, which means capital requirements are moving in the opposite direction relative to where they need to go.

“When banks perceive this kind of political pressure, my research shows that they reduce the capital … that is, they compound the effect of credit allocation regulation on risk by becoming fragile, holding less capital,” Thakor said.

It is when banks are profitable, stable and efficient that political pressure to direct credit allocation is the strongest, so in a sense we have a “built-in” business cycle where stability is almost bound to be followed by fragility, Thakor said.

Central to his newly published theory are four projected results:

  • Banking fragility is averted with higher capital requirements. The more assets on hand, the more stable the institution.
  • When banks possess more bargaining power relative to regulators, banks get lower capital requirements.
  • When political influence is greater, the banking sector is larger and more competitive, and higher capital requirements need to be higher. So politics matter in bank regulation.
  • The influence politicians will exert on banks to make politically favorable loans is stronger when banks are more profitable. Perhaps the most important point. Wrote Thakor: “The political preference for such lending may arise from social efficiency considerations (i.e. specific groups or communities), fairness/equity concerns, and/or private benefits for legislators/regulator.”

Thakor’s theory contains “predictions that hopefully will be tested empirically in future research,” he said. And points that could be discussed and debated openly, explicitly.

“Even mentioning credit allocation and capital requirements together has political ramifications,” Thakor said, “so we have not had a rigorous debate of the issue.”

Journal Link: Journal of Financial Intermediation