An approach to bank regulatory reform that restricts the scope and incentives for bank balance-sheet expansion funded by short-term debt is essential to preventing another major financial crisis. Such regulation would have prevented the collapse of Bear Stearns in the United States or Northern Rock in the United Kingdom in 2008.
In curious contrast, a "Volcker rule"—a ban on proprietary trading by commercial banks—would have done nothing to mitigate the worst financial crisis since the Great Depression. Yet implementing such a rule has become a domestic and international political miasma that is draining credibility from the postcrisis regulatory reform process in the United States. The effort should be abandoned. To make the U.S. banking sector more resilient and less dependent on taxpayer support, hard constraints on bank leverage should be implemented: banks should be prohibited from expanding their assets beyond a certain level without increasing shareholder common equity proportionately. To address the problem that banks find equity capital more expensive than debt, the massive incentives for debt financing in the tax code should be diluted, or preferably eliminated.
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