Happy Birthday, Dodd-Frank. Now Grow Up.

Dodd-Frank: It's complicated.

Photographer: Win McNamee/Getty Images

The Dodd-Frank financial reform law turns five next month. To some U.S. lawmakers, this happy occasion calls for rolling back the burdensome requirements of an act written in the dark days of a global crisis whose origins weren't fully understood. 

They have a point. The law is much too complicated and ought to be simplified. But this doesn't amount to simply rolling it back. Getting financial regulation right involves a judicious mix of strengthening some aspects of Dodd-Frank and relaxing others.

QuickTake Too Big to Fail

Senator Richard Shelby, the Alabama Republican who is chairman of the banking committee, has a proposal that could be on the Senate floor in a few weeks. As it stands, the measure is flawed; with some changes, though, it might constitute an improvement.

Shelby's bill, first, would cut unnecessary red tape for community banks. That's a good idea. These 6,000 or so institutions use their local roots and relationships to make almost a quarter of commercial loans, yet collectively control only about 10 percent of U.S. banking assets. Because they typically have more capital than the law requires and don't trade exotic instruments or conduct cross-border transactions, they are economically important without being systemically risky. At the moment, they are overregulated. 

The bill's centerpiece, though, is another story. It would raise the threshold for deeming a bank "systemically important" -- hence subject to more demanding Federal Reserve supervision -- from $50 billion of assets to $500 billion. There's something to be said for raising the threshold, but not that far.

A somewhat higher threshold is appealing because it would allow more small banks to merge without having to labor under stricter supervision. More such mergers, in turn, could lead to more competition as the biggest banks might be challenged to give up product lines that the new competitors could provide more efficiently.

Thomas Hoenig, the vice chairman of the Federal Deposit Insurance Corp., has a more radical suggestion: Have no threshold at all. Instead, he says, judge each bank's riskiness not by size but by its leverage and capital, its interconnectedness with other banks, and the types of derivatives it trades. He's right that a bank's activities should matter more than size in assessing risk. But this isn't to say that scale doesn't matter at all.

The Fed's top regulator, Daniel Tarullo, would set the bar at $100 billion. This would still free about a dozen regional banks from enhanced supervision. Recent research backs Tarullo up. One study by the Office of Financial Research (the U.S. Treasury unit that advises financial regulators) shows that the point at which credit markets begin to view banks as "too big to fail," and therefore likely to get a taxpayer bailout if insolvent, lies between $50 billion and $150 billion. A sensible threshold, high enough to allow more consolidation but low enough to ensure that risky banks are adequately supervised, serves a useful purpose. A bar of $100 billion looks appropriate.

Critics have also lodged a more fundamental objection to Dodd-Frank -- namely that requiring banks of whatever size to have more capital reduces their lending and holds back the economy. A separate study by the FDIC shows that this concern is unwarranted. Banks with higher levels of capital relative to assets had higher rates of lending throughout the last economic cycle.

Lighter regulation does make sense for banks of moderate size that aren't highly interconnected or engaged in risky activities. Acknowledging this doesn't require Dodd-Frank to be "rolled back." In all, the evidence argues for maintaining or even tightening the law's requirements on capital; lifting the systemic-importance threshold to $100 billion; and making it clear that banks below the threshold can still be deemed systemically risky, depending on their activities.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net.