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The Trump administration—not the Fed—has it right on bank regulation

  • All 34 of the largest banks in the US passed the Federal Reserve's latest stress tests.
  • The assumptions about GDP and other criteria in the stress tests were "extreme" and "absurd."
  • The Fed and the Trump administration seem to hold opposite views on bank regulation.
  • The Trump administration—and not the Fed—appears to be headed in the right direction.
President Donald Trump speaks alongside Treasury Secretary Steven Mnuchin (R) during a meeting about the federal budget in the Roosevelt Room at the White House in Washington, Feb. 22, 2017.
Saul Loeb | AFP | Getty Images
President Donald Trump speaks alongside Treasury Secretary Steven Mnuchin (R) during a meeting about the federal budget in the Roosevelt Room at the White House in Washington, Feb. 22, 2017.

All 34 of the largest banks in the United States, representing over 75 percent of U.S. banking assets, recently passed the Federal Reserve Board's annual stress tests for the first time since the tests were created in 2011. However, celebration is very premature.

The Fed's stress tests require banks to have sufficient capital to withstand levels of losses greater than the losses they suffered in the 2008 crisis. This latest test, based on economic assumptions released in February 2017, assumed that quarterly GDP growth would fall by 10.6 percent and the unemployment rate would hit 10 percent by mid-2017. In actuality, GDP is growing at 2 percent annually and the unemployment rate is under 5 percent. These assumptions were not only extreme, they were absurd.

The only way banks can pass these tests is to hold even more capital than minimum U.S. requirements, since they must meet these requirements after incurring the predicted losses. Fed stress tests thus act as the binding capital constraint for a large portion of the U.S. banking system.

Jerome Powell, governor of the Federal Reserve.
Adam Jeffery | CNBC
Jerome Powell, governor of the Federal Reserve.

The Fed is apparently not satisfied that its existing high capital requirements are sufficient. Fed Governor Jerome Powell, now in charge of bank supervision, indicated at a Senate Banking hearing this week that the Fed intends to increase the minimum capital that the eight largest U.S. banks need to pass the tests based on their size and interconnectedness with the financial system. Estimates are that doing so would increase the minimum capital that these U.S. banks would have to hold to pass the tests by an average of 57 percent!

However, the Federal Reserve and the Trump administration seem to be headed in opposite directions.

"In my view, Secretary Mnuchin — and not Governor Powell — is headed in the right direction."

Last month, Treasury Secretary Mnuchin submitted a report to President Trump suggesting reforms to the U.S. banking system that, in his view, would promote both economic growth and financial stability. The Secretary's report lays out a starkly different path for bank capital requirements and the Fed's stress tests than Governor Powell favors.

The Secretary's report made clear that high bank capital requirements reduce bank lending, particularly to small businesses and homeowners, and therefore recommended scaling back U.S. capital requirements (where they exceed international standards). The Secretary also recommends adopting a more transparent process for the Fed's annual stress tests, including making the Fed's models and economic scenarios available for public comment. Those changes would undoubtedly result in lower required capital levels.

Industry estimates are that the Treasury's recommendations could free hundreds of billions of dollars in excess bank capital that could then be returned as dividends to shareholders (which would make investment in these banks more attractive). Bank of America estimated that up to $2 trillion in additional lending would be possible, if the Secretary's recommendations are implemented.

But these industry analyses did not consider the possibility that the Federal Reserve was planning to dramatically increase the difficulty of their annual stress tests by raising the required capital needed to pass them.

It is ultimately the Federal Reserve Board that will decide how to proceed with bank capital requirements, so the Secretary's report may represent nothing more than a wish list. The uncertainty about the Federal Reserve's direction is magnified by the fact that the president has yet to nominate three new members of the board that could swing the board in the Treasury's direction. The longer he waits, the more there will be to potentially undo.

In my view, Secretary Mnuchin — and not Governor Powell — is headed in the right direction.

JPMorgan CEO Jamie Dimon recently put the excessiveness of U.S. bank capital requirements into perspective. According to his 2017 shareholder later, JPMorgan alone has enough capital to withstand the combined projected stress test losses of all thirty of the largest U.S. banks. And under Governor Powell's proposal he will need even more capital.

Jamie Dimon, chairman and CEO of JPMorgan Chase, speaks at the Economic Club of Washington September 12, 2016 in Washington, DC.
Win McNamee | Getty Images
Jamie Dimon, chairman and CEO of JPMorgan Chase, speaks at the Economic Club of Washington September 12, 2016 in Washington, DC.

High minimum capital requirements also cannot prevent financial crises.

As Warren Buffett said in his testimony to the Financial Crisis Inquiry Commission—a group organized by the U.S. government to investigate the 2008 financial crisis—even with high capital, short-term creditors are still incentivized to withdraw their bank deposits in a crisis, forcing banks to fire-sell their assets. And the losses from fire sales would quickly overrun even the capital levels that Governor Powell is advocating.

Ultimately, according to Mr. Buffett, only the U.S. government, specifically the Fed as lender of last resort, can stop a financial panic.

He is right. What we need is for the Federal Reserve to be prepared for a future financial crisis by adopting a rule of law framework that would protect solvent financial institutions and avoid lending to insolvent ones. This would include a plan for valuing and lending against bank assets that would be pledged to the Fed as collateral.

Therefore, if we want to get serious about U.S. economic growth and making the financial system safe then the right answer is to consider lowering bank capital requirements—and certainly not raising them — and focus on strengthening the Fed's preparedness to prevent and respond to a panic.

Commentary by Hal Scott, a professor of international financial systems at Harvard Law School and director of the Committee on Capital Markets Regulation. Follow him on Twitter @HalScott_HLS.

For more insight from CNBC contributors, follow @CNBCopinion on Twitter.

Watch: Kroszner on reassessing bank regulation