The “norming” mentality led to weak regulations and an under-capitalized banking sector, and cost-benefit analysis is the best approach to regulate banks, says Chicago Law School.

Eric A. Posner of the University of Chicago published a report in September with the title: “How Do Bank Regulators Determine Capital Adequacy Requirements?” He notes it has never been clear how regulators determine the minimum capital-asset ratio.

Insufficient bank capitalization

The author notes that the incentive to take socially costly financial risks is inherent in banking. Such a perverse incentive to take financial risk is further aggravated by underpriced government-supplied insurance and the government’s readiness to play the role of lender of last resort.

Tracing the five regulations issued over more than 30 years, the author points out that U.S. regulators have issued rules since 1981 that set out minimum capital-asset ratios. However, the author notes also that the ratios mandated by those rules were always too low and that they were so riddled with exceptions that they could be easily evaded.

Posner explains that market forces alone caused most banks to maintain higher capital-asset ratios than were required by the rules. The author emphasizes that insufficient capitalization of banks contributed to the financial crisis of 2007-2008.

“Norming” mentality

Analyzing various regulatory documents, the author reports that regulators repeatedly assured banks that the regulations would not affect the vast majority of them. This “norming” style of regulation has chosen a regulatory standard that doesn’t interfere with the mean or modal behavior of regulated entities, which the author believes likely contributed to the financial crisis.

As can be deduced from the following graph, the author points out that the average ratio of capital to assets of U.S. banks since 1950 provides no evidence that the new capital regulations changed banks’ portfolios.

Bank CAR and Legal Requirements cost-benefit analysis

Interestingly, the author also points out that such capital adequacy rules were like 200 mile per hour speed limits that no one exceeds because their cars can’t drive so fast.

Cost-benefit analysis is the ideal way

Posner suggests that cost-benefit analysis is the best approach to regulate banks, as it would force regulators to lay out explicitly what they think the costs and benefits of a capital adequacy rule might be. While on the cost side, a capital adequacy rule requires banks to switch at the margin from debt to equity, on the benefit side, the rule would reduce the risk of a financial collapse and the massive costs associated with it. The author emphasizes that although estimating these costs and benefits is challenging, it isn’t impossible to perform such an analysis for financial regulations.

The author concludes that had regulators used cost-benefit analysis, they would have produced stricter capital-adequacy rules, which would have caused banks to enhance their capital-asset ratios.