After the financial crisis, the government, in the form of the Federal Reserve, the Comptroller of the Currency and the Federal Deposit Insurance Corporation, imposed liquidity requirements that force American banks with assets over $50 billion to hold huge amounts of government debt as liquid assets.
Those assets represent $4.3 trillion in government debt, or about one-quarter of all American banking assets. They include $1.75 trillion in bank deposits (called excess reserves) held at the Fed, $1.5 trillion in mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac (called government-sponsored-enterprise debt) and $560 billion in United States Treasuries.
American banks are truly awash in government debt at five times pre-crisis levels. If President Trump wants to follow through on his promise to increase lending to small businesses, he should start by scaling back these requirements.
Why do we have these rules? They are based on the idea that financial institutions need a cushion to protect them from runs on the bank. During a crisis, government debt can quickly be sold to meet withdrawals by panicking depositors and short-term creditors.
But bank liquidity requirements come at a very high cost to the economy. Studies find that they reduce overall bank lending by 3 percent to 5 percent, and increase interest rates by 15 to 30 basis points. And indeed, small-business lending is down in the time since regulators imposed them.
Ultimately, according to a survey of studies by the Treasury’s Office of Financial Research, liquidity requirements reduce economic growth by as much as three percentage points.
These liquidity requirements will continue to tie banks’ hands even if the Fed shrinks its balance sheet. When the Fed reduces its holdings of United States Treasuries and mortgage-backed debt, it must also reduce excess reserves that banks rely on to comply with liquidity requirements. As a result, American banks will have to buy more Treasuries and mortgage-backed debt and thus will not have increased spare capacity to lend privately to the small businesses and homeowners who need loans.
Considering that the cost of bank liquidity requirements is clearly so high, they should provide commensurate stability to the financial system. Unfortunately, there is good reason for skepticism on this front.
First, liquidity requirements cannot reduce the risk of a panic outside the commercial banking sector, like the panic in 2008 that included the otherwise solvent investment banks Goldman Sachs and Morgan Stanley, the affiliated broker-dealers of large banks and money market funds.
Second, bank stores of government assets, while large, are still finite. Therefore, while those assets may reduce banks’ need to hold a fire sale of harder-to-value assets, like small-business loans and mortgages, it does not eliminate the risk of a panic. Depositors and short-term creditors still have an incentive to run in a crisis.
Worse still, bank liquidity requirements may worsen a crisis as banks are forced to hoard liquid assets and are thus unable to lend to one another. That’s the worst medicine: In a crisis, you want banks to lend to other institutions that need money.
Several prominent conservative economists and I have recently called for the Federal Reserve to establish a framework for any Fed lending during a financial crisis.
A key contributor to the crisis in 2008 was that the Fed was simply not prepared, and therefore the market had no confidence that any financial institutions would be protected. Rather than relying on costly and untested liquidity requirements, what we need is for the Fed to have a plan for how it would value and lend against private collateral, including small-business loans and home mortgages, held by solvent financial institutions. Solvency determinations during a fast-moving crisis are too difficult.
The Fed must plan ahead to protect the financial system by making loans immediately to solvent banks based on their balance sheets and avoid lending to insolvent institutions, such as A.I.G. in 2008.
Liquidity requirements can’t save us from the next crisis, and they can make that crisis worse. In the meantime, all the money stockpiled in banks would be better spent invested in companies to spur economic growth.
Hal S. Scott, the director of the Committee for Capital Markets Regulation, an industry-supported research group, teaches international finance at Harvard Law School.
A version of this op-ed appears in print on May 15, 2017, on Page A19 of the New York edition with the headline: To Grow, First Free The Banks. Today's Paper|Subscribe