04/04/2012 06:31 pm ET Updated Jun 04, 2012

Meddling in Banks Causes Its Own Perils

After four of the 19 biggest financial institutions failed Federal Reserve's stress tests, it drew a line marking the industry's "winners" and "losers." Winners got to raise dividends and buy back stock, driving up stock prices. The losers remained in a position where the Federal Reserve was making their decisions about what to do with their capital.

This sort of regulation and oversight poses a great hazard to the banking industry. While there is a duty to prevent fraud and offer oversight on the part of the Federal Reserve, the Federal Deposit Insurance Corp (FDIC), Comptroller of the Currency and other regulators, intrusive actions could stifle financial innovation.

The more that the government does to take the decision making away from people running the banks and substitutes its own judgment, the greater the risk that the banking industry emerges into something resembling the U.S. Postal Service, which is struggling to adapt to change but is constrained by a combination of government oversight and an array of legacy costs.

During the past 40 years, financial services has been one of the industries in which the United States has a competitive advantage that has been exported to the world.

These stress tests came about after $245 billion in federal funds was provided to the banking industry under the Troubled Asset Relief Program during the financial crisis of 2008. According to Bloomberg News, The Fed had committed $7.77 trillion in financing as of March 2009 to rescue the financial system with funds largely going to a small group of the largest banks. Yet, stress tests prior to 2008 failed to detect weakness at the banks.

A column that appeared on by Jonathan Weil points to flaws in the Fed's approach to the stress tests, which were designed to test what would happen during an economic downturn, leading to higher unemployment and a drop in housing prices. The column found the government's approach to the stress test to be window dressing to boost confidence rather than perform reliable measures of financial health. The stress test didn't take changes in liquidity or market conditions into account when looking at potential losses on securities.

The scope of the Federal Reserve and federal government's intervention to support banks as "too big to fail" has created its own set of problems. The perception is that a safety net is available to big banks anytime they get overextended and the taxpayers will be dragged into saving them.

We are creating monumental problems down the road from regulators pursuing this disruptive, counterproductive and dysfunctional course of protecting the banks and also intervening with their operations.

If there is a crisis with these banks that are regarded as too big to fail, there are tools in place to place them into receivership to protect depositors and other creditors. The proper way to do it would be to replace management, ensure liquidity with counterparties and place more of the onus on equity holders to bear some of the risk for failure. The bailouts had been too lenient on equity holders, despite the requisite drops in share price since 2008. The banks that received bailout funds without making management changes shows a degree of failed governance, as well. Poor governance can also be punished by the marketplace, since those companies will suffer from stagnant or declining share prices if they continue to keep underperforming, but entrenched management.

At the heart of this matter, regulators need to realize that banks are too important of a part of America's economy to micromanage. Regulators should just assure that investors are not being defrauded and that the banks are being transparent about their performance to investors and prospective investors, meaning they should not be dictating how balance sheets should look and how capital should be deployed.

When regulators overstep their role and take too great of control, investors and ultimately the customers will be hurt by poorer service, a lack of innovation and unmet needs when it comes to managing risk or raising capital necessary to expand businesses or purchase goods. The American public then becomes the big loser from regulatory meddling.

Clifford W. Smith is the Louise and Henry Epstein Professor of Business Administration and Professor of Finance and Economics at the University of Rochester's Simon School of Business.