Regulatory Burden Handicaps Low-Risk Banking

A growing number of nonfinancial firms, including Eastman Kodak, have found that raising funds in the commercial paper market is less expensive than borrowing from banks. Between 1975 and 1986, banking's share of short-term borrowing by major manufacturers declined from 48% to 27%. Most of this loss is attributable to the mounting importance of commercial paper. The application of a single capital ratio for all types of assets has had an inadvertent effect on the competitiveness of banks in the low-risk loans market. Expanded powers for bank holding companies probably would not make the banks themselves more profitable. Better solutions to this problem include: 1. permitting banks to substitute subordinated debt for equity capital, thereby enabling regulators to increase the banking system's capital buffer without dampening the system's power to compete in the low-risk loan market, and 2. distinguishing between low-risk and high-risk commercial loans when calculating a bank's minimum capital ratio.