How a fatter cushion might make us all sit a little bit more comfortably. By Richard DeKaser, Contributing Economist July 1, 2010 Editor's note: This story has been updated. Will financial reform slow economic growth? In the short term, yes. Longer term ... just the opposite. The legislation signed by the President July 21 will reduce risk, increase stability and, over time, promote economic growth.Like all legislation born in the aftermath of a crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act targets the obvious flaws that contributed to the crisis—in this case, the financial disaster of 2008-2009. For home buyers who took out incomprehensible mortgages, there will now be more disclosure. For credit card holders surprised by hidden late fees, there will now be limits. For investors who stumbled into inscrutable derivatives, there will now be clearer explanations and more standardization. And for lenders that embraced big risks, there will be increased capital requirements. It’s this last item that’s the most critical. Capital reserves are, in effect, a cushion. When a bank suffers a loss, its capital is depleted on a dollar-for-dollar basis. As the cushion grows thinner, the solvency of the institution weakens, and in the extreme case, when a bank fails, its investors suffer the loss. In a perfect world, the losses are limited to the shareholders invested in the bank -- capitalism at its best. But in the highly imperfect world in which we reside -- where the failure of a megabank, with tentacles reaching far and wide, triggers a cascade of failures elsewhere -- the taxpayer is left holding the safety net. Advertisement The legislation ups the ante for financial institutions, requiring a fatter capital cushion. Derivatives dealers and clearinghouses, for example, will be forced to hold capital reserves for the first time. And proprietary trading -- speculative investing for a bank’s own account -- must be spun off to separately capitalized, insulated entities, if it exceeds a set share of the banks’ assets. Most important, regulators will get an almost free rein to increase capital requirements as they see fit. In practice, bank regulators set capital standards as ratios -- until the 2008 near-meltdown, a 10% ratio was typical for the banking industry as a whole: Each dollar of capital supports $10 of loans. For super-safe loans, such as those to the U.S. Treasury, lenders aren’t required to hold any capital at all. For riskier ventures -- such as those undertaken in the lending spree of a few years ago -- the capital required may be higher than 10%. Critics say increasing capital requirements will hurt bank profits and restrain economic growth. Mark Zandi of Moody’s Economy.com, for example, asserts that “the bill will reduce credit to business and households by $80 billion a year, in part because it will make banks less profitable.” He estimates it will shave $65 billion off economic output over a decade, or about 0.3% -- and that doesn’t take into account any new capital rules still being worked out by global regulators. They’re right, in the short term. Banks will have to pay more, in the form of higher dividends on common stock, to attract the needed capital. And because they’ll need to hold more funds back, they’ll have less to lend out and generate revenue. But that’s only half the story. Bank profits based on inadequately capitalized lending ultimately aren’t sustainable, as recent history makes clear. The fabulously profitable subprime loans of 2005 turned into the toxic waste of 2008. And the strong economic growth that always accompanies excessively relaxed bank lending is routinely followed by subpar performance and tight credit as lenders suffering loan losses attempt to replenish capital that wasn’t ample in the first place. Advertisement Over the long term, a better alignment of capital cushions with risk taking is sensible. As former Federal Reserve Chairman Alan Greenspan notes, contagion does not arise, if firms have adequate capital. By definition, that means they won’t default on debt obligations. Transitioning to a brave new world of increased capital standards will incur some economic costs: dollars channeled into cushions, rather than loans, and economic growth slower than it would otherwise be. But once the task is complete, the result will be a more resilient financial system. And that means less risk, which promotes superior economic performance.