How to solve the bank capital Goldilocks question

May 6, 2013, 5:54 PM UTC

FORTUNE — Recent efforts to raise bank capital requirements are off the mark. Forcing the big banks to hold on to a greater share of their assets as a way to boost the safety of the nation’s financial sector may seem like a no-brainer, but it ignores how vulnerable the banking system is to short-term financing. Regulators should be more interested in what is going on in the shadows if they ever hope to avoid encountering yet another too-big-to-fail moment.

There has been a surprisingly great deal of ink spilled recently about a proposed bill by Senators Sherrod Brown, (D-OH) and David Vitter, (R-LA) that would force the big banks to increase the amount of capital they hold relative to their assets to as high as 15%. It is surprising on two accounts: First, because the bill has pretty much a snowball’s chance in hell of actually becoming law; and second, because there has been little discussion as to the merits of bank capital in relation to bank safety.

After the 2008 financial crisis it seems amazing that bank capital ratios — whether they are risk-weighted, as they are required today under the Basel agreements, or not, as preferred by Brown-Vitter and its champions — continue to be considered the only credible measure of bank stability. Banks in the 21st century live and die based on blind and irrational faith, nothing more. To say that the U.S. banking system would be safer if the big banks put aside a collective $910 billion, as estimated by SNL Financial, against their collective multi-trillion dollar balance sheets, misses the mark in a multitude of ways.

First of all, bank capital requirements are a relatively new phenomenon. In the U.S., the first rules that explicitly required banks to hold some cash on the sidelines relative to their assets came into being in 1981 and weren’t enforced until the summer of 1985. The rules specified that banks were required to hold cash or short-term securities equal to 5.5% of their assets. Later, an international agreement, Basel I, was struck, which required banks with an international presence to hold capital equal to 8% of their so-called “risk-weighted assets.”

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That agreement was updated in 2004, becoming Basel II, which, funny enough, many U.S. banks are still in the process of implementing. Basel III, the post-financial crisis version, is currently in the works. It would force banks to hold even more capital than before, with the big banks required to hold a bit more capital than smaller banks. This was to take into account the “systemic” dangers associated with failures like Lehman Brothers.

Trying to prevent another Lehman Brothers is an admirable fight, but it needs to be fought intelligently. It should be understood that the primary focus of the Basel accords is to harmonize capital rules so as to ensure that banks compete on a level playing field. Basel wants to make sure that no bank has a regulatory advantage over another. Safety, while important, rides at the back of the bus. As such, the Basel accords are reactionary, mirroring what the industry wants against those that regulators want. Brown-Vitter has caused a kerfuffle on the Street because it is proposing bank capital rules that supersede Basel III. The worry here is that U.S. banks won’t be able to compete as strongly against foreign banks.

Capital cushions keep money on the sidelines that would otherwise be used by the banks to make more money, whether that be lending to a small business or buying a bunch of securities. What capital cushions don’t do is prevent bank failures. That is because banks are constantly on the hook for ungodly sums of money in their role as a broker-dealer. One hiccup in this delicate funding cycle, and it’s curtains for the banks.

This whole funding system is very complicated. Banks make a great deal of their money by essentially being a sort of “warehouse of risk” for the greater financial community. This is done through their role as a market maker and as a de facto clearinghouse. Private capital, like hedge funds and pension funds, uses the banks as a conduit to access the markets — the funds trust the banks in this capacity because they have big balance sheets and lots of funding to execute trades and the like.

So where does this money come from? Depositors? No. The banks finance their broker-dealer operations primarily through short-term financing made available to them by the rest of the financial community — so essentially the same funds that are using the banks as a conduit to access the market. This circular funding game is known as the repo market, and it is big and opaque. This market came about because private capital needed a place to safely park large sums of cash. In the repo market, this cash is lent to the banks on a short-term basis, usually overnight. The banks turn over collateral to the lenders usually equal to 100% of the value of the cash. This collateral can technically be anything, like U.S. Treasuries or, as was the case during the financial crisis, asset-backed securities that were deemed to be investment grade.

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So let’s jump right to the scary part. The repo market is huge and basically unregulated. We actually have no idea how big it is — there have been estimates as high as $12 trillion. What we do know is that a month before Lehman Brothers collapsed the banking system held cash reserves equal to around $50 billion while clearing $2,996 trillion in trades per day. That means the banks were technically liable for all of those trades at any given point in the day. Thus private capital trusted the banks to clear and process their trades, pay them if anything went wrong, and pay them interest on the loans they extended to them to make it all happen.

Confusing? Yes. Madness? Depends on who you talk to, but the general feeling on Wall Street is that this is simply the way the world works. It is all contingent on faith. Repo is the grease in this machine, and the second it stops flowing it seizes up. The reason why Bear Stearns and Lehman collapsed was because private capital lost faith in their ability to function as broker-dealers. They didn’t trust the collateral they were putting up (structured “toxic” credit) to obtain their repo funding, so they started to lend less money than the assets’ booked value. Eventually they stopped lending altogether. With around 50% of bank assets funded through the repo market it took only a couple days without it for both Bear and Lehman to collapse.

If Bear and Lehman had had fatter capital cushions they may have lasted a couple days longer before collapsing, but no more. This is the futility of bank capital. It gives a false sense of security. Those asset-backed securities the banks used as collateral were rated as AAA and thus were assessed as riskless. This meant the banks could book them at 100% of market value in their risk assessment under Basel (of course they turned out to be worth much less than book value). The same mistake is being made under Basel III, which is supposed to “fix” the problems of Basel II. For example, under Basel III, banks can book local sovereign bonds as being totally riskless, meaning that they will carry their full value. Really? That means Greek banks can book Greek sovereign debt at 100% of its value even though the world has to book it at a 30% discount.

At the end of the day, though, it really doesn’t matter how big a bank’s capital cushion is or even what it is made of. The loss of repo funding will overwhelm any bank even if it has a lot of great capital as it would be difficult to liquidate those assets fast enough — in any market environment — to provide the necessary cash to fund their broker-dealer operations. The market is not a rational force, and sometimes it acts up. After Lehman, repo funding fell for the next seven quarters to as low as $900 billion. The government came to the rescue by making up for whatever the repo market took off the table by allowing banks to borrow as much cash as they liked from the Federal Reserve.

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The government is the real capital buffer here and it always will be — it’s the only entity with a balance sheet big enough to finance the repo markets. This will not change by making the banks hold a few measly extra billion dollars on the sidelines — we are talking about trillions of dollars. No one can control the collective behavior of the repo markets. If those who provide repo funding collectively decide to pull all their cash out of the market in one day then that is their prerogative.

What may be needed here is some sort of FDIC-like structure to protect lenders in the repo market from defaulting banks. Such a structure has worked very well in the U.S. in quelling bank panics. During the financial crisis lines to withdraw cash were not seen as they were during the great bank panics of yesteryear. That is because the money that was withdrawn was done so in a blink of an eye in the repo markets.

It stands to reason that such a deposit insurance scheme could work at halting runs on the repo market as it has done successfully in halting runs in the depositor market. If Brown and Vitter are serious about saving the banking system, maybe they should look into doing something like that.

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