Economist: Dodd-Frank Has Created a ‘Path of Least Resistance’ for Bank Bailouts

“What we know from the way regulators behave does not give us a lot of confidence to believe that the FSOC is going just by virtue of its existence to change much about credible discipline of large banks when you need it, which is during bad economic times,” Calomiris said.

He said FSOC does not present a very serious commitment to reining in “too big to fail” because politicians and regulators will continue to have strong incentives during bad times to “forebear”– or allow troubled banks to continue operating by “not recognizing losses in a very transparent or proactive way.”

Calomiris said banks and their regulators often find it convenient to understate expected loan losses, and thereby overstate equity values. Banks have the incentive not to recognize loan losses because doing so might require them to raise more capital, which they can do through various ways, such as issuing new equity or retaining earnings.

Similarly, regulators also have the incentive to ignore losses because it is inconvenient for politicians. This problem is exacerbated when equity requirements are expressed relative to “risk-weighted assets,” which allow banks and regulators to determine which kind of investments are safe and have a lower capital requirement and which are risky and require more capital to back them.

Even if the book value of equity was honestly being accounted for to be considered an accurate measure of the health of a bank, Calomiris said book value of capital is not a very precise indicator of a modern bank’s health because items that lie off their balance sheets, such as securities, drive most of its cash flows. This makes the job of regulators much harder when trying to assess the right level of capital a bank should hold to be considered healthy.

Mark Flannery, an economist at the University of Florida, said fixing capital requirements is unlikely to end the too-big-to-fail problem because they are tied to book capital measures, which are easily manipulated by banks.

“The regulations were all written in terms of book value. A banker can always say to look at its book capital ratio showing that it’s adequately funded,” Flannery said. “So now the supervisors have to…discredit the accounting numbers. Not that it can’t be done, just that it’s a long process.”

He said supervisors have been put in an extremely difficult position by being tasked with trying to take steps for the dispersed good of maintaining a healthy financial system, while imposing costs on a limited number of people (the bank’s shareholders).