What makes banks special is that confidence in our banking system is required for our economy to operate smoothly. After the stock market crash of 1929, savers rushed to their bank to withdraw their cash in fear that their bank would go out of business and they would lose their savings. A “run on the bank” could shut down our financial system completely. Recall that the bank in our example doesn't actually have $90 million in cash that they accepted from depositors. They lent it out so that they could earn a spread (also called the “net interest margin” or NIM).

GlobeSt.com: Do these regulations help prevent a “run on the bank?”

Brzeski: To calm savers so that they don't have to worry about a run on the bank, the banking system features two safety nets, both of which are backed by taxpayers like you and me. First, the Federal Deposit Insurance Corporation guarantees that you will get your money out of your bank account, even if the bank fails (up to $100,000 per account). There is no need to rush down to the bank at the first sign of trouble, which is good because having lots of depositors rushing to withdraw their money at the same time is exactly what creates the largest problems for the financial system. Second, banks are able to borrow from a government backed bank–the Federal Reserve Bank–at any time, as needed to meet requests for withdrawals and other short term liquidity demands. If the savers in our hypothetical community bank all wanted their deposits withdrawn on the same day, the community bank can borrow the money needed to meet the request, even though the money has been lent out for months or years at a time to local businesses and they don't actually have the cash in their vaults. And what if the Federal Reserve doesn't have enough cash to meet all the requests from banks? They can simply print the money, without any limitation. Alternately, the Federal government can borrow the money from investors by issuing Treasury bonds. That's why you'll see that every denomination of U.S. currency is signed by the Chairman of the Federal Reserve Bank and by the Treasury Secretary.

GlobeSt.com: What do you think about the heavy regulation that banks face today?

Brzeski: Banks are regulated heavily for a very good reason. They are essentially public utilities, like roads and highways. If they make foolish errors and lose all their money or go bankrupt, guess who ultimately has to pay the bill? You and I as taxpayers, that's who. How? Suppose that in order to replace the money that a bank loses, we sell Treasury bonds to investors in other countries. That money eventually needs to be paid back by taxing us all. The actions of bankers have consequences that go far beyond themselves and the investors in their banks. They affect all of us.

GlobeSt.com: What are bank regulators focused on, and what should they focus on?

Brzeski: There are two main factors that bank regulators tend to care about. The first one is the riskiness of the loans that banks make. The second one is the leverage that banks use in their own balance sheets. Recall that in our example, the community bank had $10 million of investor capital and $90 million of deposits. Suppose instead that the bank had $400 million of deposits for every $10 million of investor capital. The margin of safety for that bank would be very different and the risk of a taxpayer bailout would be much higher.

After the financial crisis, bank regulators introduced rigorous “stress tests” for the largest banks to make sure that they wouldn't fail even under a wide range of possible economic scenarios. Smaller banks face regular audits designed to identify weaknesses. Of particular concern are loans on properties that may drop in value dramatically in a short period of time, known as “high volatility commercial real estate” or HVCRE loans.

One of the greatest objections voiced by bank executives is that they don't know exactly how regulators will view a particular loan versus a slightly different loan, or how the same loan will be categorized over time. Banks fear that certain loans will be viewed negatively by regulators, requiring higher reserves. The net effect of loans being classified negatively is that the returns earned by the owners of the bank will be lower, all other things remaining equal. In order to avoid the chance of regulators judging a particular loan harshly at the next stress test or audit, banks tend to avoid any loan that might be judged harshly, sticking instead to loans that fit safely within the regulators' preferred lending box. This reluctance of banks to take on regulatory exposure, more than any other factor, has laid the groundwork for the rapid growth of non-bank lenders, including fintech companies.

While bankers may complain about it, one can make a strong case for leaving regulators a fairly large amount of discretion in how to judge banks' individual loans and overall balance sheets. Very few people anticipated the meltdown that led to the financial crisis in the late 2000s–a crisis which under slightly different circumstances could have led to a global depression similar to that of the 1930s. Better to have unhappy bank executives complaining about too much uncertainty than to risk a repeat of the recent financial crisis–particularly given the fact that you and I may have to foot the bill if it happens again, through higher taxes. In any case, what's wrong with more business flowing to non-bank lenders rather than banks?

GlobeSt.com: Last thoughts?

Brzeski: Yes, a note about leverage: In our community bank example, the bank had $9 of deposits for every $1 of equity capital. This is known as “nine turns of leverage.” In contrast, a lender that borrowed $1 for every $1 of equity capital would have one turn of leverage. We will return to this useful definition later in the article.

Earlier this week, Jan B. Brzeski, managing director and chief investment officer of Arixa Capital Advisors and Crosswind Financial, questioned whether non-bank lending platforms, which have tremendous growth in recent years, should be regulated like a bank lending platform. Now, we sat down with Brzeski to take a closer look at bank lending. In this exclusive interview, we ask Brzeski how bank lending is regulated, what regulators focus on, and why banks are so heavily regulated today.

GlobeSt.com: Earlier this week, you questioned if non-bank lending platforms should be regulated the same as banks. Can you give us a closer look at how bank lending is regulated?

Jan B. Brzeski: By all accounts banks have faced tough regulation in recent years. The best argument for regulating banks has to do with their special role in our economy: banks accept deposits that are guaranteed by taxpayers. Let's take an example of a community bank that is started by a group of investors with $10 million of their own money. They open an office and let's say they offer a 1.5% interest rate to local residents on their savings accounts. This rate is higher than most banks offer, so they attract $90 million of deposits from a wide range of households and businesses. They now have $100 million in cash, which they lend out to local businesses and consumers in the form of credit lines and mortgages on various types of real estate. Suppose the bank charges a 5.5% interest rate on their loans. They make a 4% spread on every dollar they lend, over and above what they pay their depositors. Using rough numbers, they have $5.5 million of interest income (5.5% x $100 million) and $1.35 million of interest expense (1.5% x $90 million). Their income before costs such as payroll is $4.15 million.

GlobeSt.com: The need to avoid a run on the bank.

What makes banks special is that confidence in our banking system is required for our economy to operate smoothly. After the stock market crash of 1929, savers rushed to their bank to withdraw their cash in fear that their bank would go out of business and they would lose their savings. A “run on the bank” could shut down our financial system completely. Recall that the bank in our example doesn't actually have $90 million in cash that they accepted from depositors. They lent it out so that they could earn a spread (also called the “net interest margin” or NIM).

GlobeSt.com: Do these regulations help prevent a “run on the bank?”

Brzeski: To calm savers so that they don't have to worry about a run on the bank, the banking system features two safety nets, both of which are backed by taxpayers like you and me. First, the Federal Deposit Insurance Corporation guarantees that you will get your money out of your bank account, even if the bank fails (up to $100,000 per account). There is no need to rush down to the bank at the first sign of trouble, which is good because having lots of depositors rushing to withdraw their money at the same time is exactly what creates the largest problems for the financial system. Second, banks are able to borrow from a government backed bank–the Federal Reserve Bank–at any time, as needed to meet requests for withdrawals and other short term liquidity demands. If the savers in our hypothetical community bank all wanted their deposits withdrawn on the same day, the community bank can borrow the money needed to meet the request, even though the money has been lent out for months or years at a time to local businesses and they don't actually have the cash in their vaults. And what if the Federal Reserve doesn't have enough cash to meet all the requests from banks? They can simply print the money, without any limitation. Alternately, the Federal government can borrow the money from investors by issuing Treasury bonds. That's why you'll see that every denomination of U.S. currency is signed by the Chairman of the Federal Reserve Bank and by the Treasury Secretary.

GlobeSt.com: What do you think about the heavy regulation that banks face today?

Brzeski: Banks are regulated heavily for a very good reason. They are essentially public utilities, like roads and highways. If they make foolish errors and lose all their money or go bankrupt, guess who ultimately has to pay the bill? You and I as taxpayers, that's who. How? Suppose that in order to replace the money that a bank loses, we sell Treasury bonds to investors in other countries. That money eventually needs to be paid back by taxing us all. The actions of bankers have consequences that go far beyond themselves and the investors in their banks. They affect all of us.

GlobeSt.com: What are bank regulators focused on, and what should they focus on?

Brzeski: There are two main factors that bank regulators tend to care about. The first one is the riskiness of the loans that banks make. The second one is the leverage that banks use in their own balance sheets. Recall that in our example, the community bank had $10 million of investor capital and $90 million of deposits. Suppose instead that the bank had $400 million of deposits for every $10 million of investor capital. The margin of safety for that bank would be very different and the risk of a taxpayer bailout would be much higher.

After the financial crisis, bank regulators introduced rigorous “stress tests” for the largest banks to make sure that they wouldn't fail even under a wide range of possible economic scenarios. Smaller banks face regular audits designed to identify weaknesses. Of particular concern are loans on properties that may drop in value dramatically in a short period of time, known as “high volatility commercial real estate” or HVCRE loans.

One of the greatest objections voiced by bank executives is that they don't know exactly how regulators will view a particular loan versus a slightly different loan, or how the same loan will be categorized over time. Banks fear that certain loans will be viewed negatively by regulators, requiring higher reserves. The net effect of loans being classified negatively is that the returns earned by the owners of the bank will be lower, all other things remaining equal. In order to avoid the chance of regulators judging a particular loan harshly at the next stress test or audit, banks tend to avoid any loan that might be judged harshly, sticking instead to loans that fit safely within the regulators' preferred lending box. This reluctance of banks to take on regulatory exposure, more than any other factor, has laid the groundwork for the rapid growth of non-bank lenders, including fintech companies.

While bankers may complain about it, one can make a strong case for leaving regulators a fairly large amount of discretion in how to judge banks' individual loans and overall balance sheets. Very few people anticipated the meltdown that led to the financial crisis in the late 2000s–a crisis which under slightly different circumstances could have led to a global depression similar to that of the 1930s. Better to have unhappy bank executives complaining about too much uncertainty than to risk a repeat of the recent financial crisis–particularly given the fact that you and I may have to foot the bill if it happens again, through higher taxes. In any case, what's wrong with more business flowing to non-bank lenders rather than banks?

GlobeSt.com: Last thoughts?

Brzeski: Yes, a note about leverage: In our community bank example, the bank had $9 of deposits for every $1 of equity capital. This is known as “nine turns of leverage.” In contrast, a lender that borrowed $1 for every $1 of equity capital would have one turn of leverage. We will return to this useful definition later in the article.