There is a downside to policymakers' infatuation with capital — and I'm not talking about industry claims that credit will evaporate.

The real problem is everything else in the Dodd-Frank Act that's getting short shrift while federal regulators fascinate over the power of capital rules to reform the banking business.

The list of sidelined goals is long: curbing interconnectedness; taming derivatives; capping leverage; rebuilding liquidity; banning proprietary trading; enhancing prudential standards; and slowing concentration.

Sure, requiring higher capital may have spillover effects, helping to accomplish some of those objectives. And, yes, the federal agencies have made some progress on some of these rules. But clearly regulators have consciously chosen to toughen capital rules over actually implementing many of the provisions in Dodd-Frank that were designed to prevent a repeat of the 2008 financial crisis.

"Banking regulators are focusing too much on capital at the expense of putting in place the necessary rules on counterparty risk, leverage, concentration, prudential standards, among others," says Dennis Kelleher, the president and chief executive officer of Better Markets Inc., a nonprofit founded to "promote the public's interest on Wall Street." "There are no silver bullets. The regulators have to get all these pieces in place for financial reform to work and for taxpayers to be protected."

Kelleher, a former firefighter, argues that financial supervision is a lot like fire prevention. There isn't just an extinguisher in a building's lobby. There is one on every floor, along with a sprinkler system, stairways and escapes. A fire department backs all that up, and can be called when these protections fail.

So we need a tough, independent exam force demanding compliance with not only strong capital rules but the other fixes called for in Dodd-Frank.

While it's true that higher capital requirements may curb proprietary trading, that doesn't give the regulators a pass on writing the Volcker Rule.

"I think they've decided it is either too complicated or pointless to try and implement" much of Dodd-Frank, "so instead they'll just require a lot more capital," says one industry veteran who didn't want to be named.

And while higher capital requirements may accomplish some of these other policy goals, they may not achieve the one goal everyone is so focused on: making the largest banks smaller.

Not a single banker I called for this column said he thought the largest banks would shrink in the wake of higher and stronger capital minimums.

That may be wishful thinking. Time will tell.

But for now executives claim the eight largest banks subject to the highest capital standards have no intention of selling off huge chunks and argue it would take years to shrink organically below $700 billion. (The new leverage ratio will apply to firms over that asset threshold.)

"Who exactly is going to buy those assets?" one banker asked. Regulators aren't likely to approve any intra-industry deals and few companies are itching to enter the highly regulated banking business.

And at best, these behemoths will shrink slowly over time. (And I'm not convinced that's such a great outcome either. The economy needs a banking industry that's growing, not hunkering down.) Karen Shaw Petrou, the co-founder and managing partner of Federal Financial Analytics, says it's too soon to assess the impact higher capital ratios will have on the largest banks.

"The first thing they are going to do is fight," she says, "and the second thing they are going to do is model."

By that she means the banks will "go through their asset positions, client by client, and run them on an economic capital allocation model. The ones where they can still make money, they'll do, and the ones where they still make money if they make some changes, they'll try, and the rest of them? They walk," Petrou says.

"So that easily could make them smaller. Not less risky, but smaller."

Bankers agree with her on the question of risk.

Jacking up the leverage ratio, which in some cases may make it the binding requirement over a risk-based measure, is likely to lead banks to load up on riskier assets. In fact some bankers argue the higher leverage ratio will kill the market for government bonds as banks shun safe assets that will now require more capital.

I've argued in past columns that implementing Dodd-Frank could lead to a regulatory system that is too complicated to comply with or to enforce. I still believe that. But putting all of our chips on capital strikes me as the other end of the supervisory spectrum — simpler, perhaps, but less effective, too.

Writing rules is hard work. I get that. But the agencies need to strike a better balance between relying on capital to curb risks in the system and finishing rules designed to address specific problems like counterparty risk, leverage and liquidity.

Subscribe Now

Access to authoritative analysis and perspective and our data-driven report series.

14-Day Free Trial

No credit card required. Complete access to articles, breaking news and industry data.