Deutsche Bank AG (DBK) recently separated its U.S. investment bank from its bank holding company, removing it from supervision by the Federal Reserve.

So far, U.S. regulators have reacted passively to such moves by foreign banks to avoid the heightened capital requirements mandated by the Dodd-Frank Act.

That’s because Dodd-Frank failed to heed a fundamental law of architecture: Form must follow function. For financial regulation to be effective, it should focus on economic function, rather than legal form. If it doesn’t, institutions will quickly find new forms that free them of regulatory constraints. What walks like a duck and quacks like a duck must be regulated as a duck, even if it is legally a goose.

All too often financial regulation misses this obvious point. The result is regulatory arbitrage, as intermediaries alter their legal form to minimize their costs.

That would be fine if the costs of the risks carried by a large, complex investment bank -- a prime example of a “systemically important financial intermediary,” or SIFI, that Dodd-Frank sought to regulate -- were all its own. But that isn’t the case. When such institutions take risks, they can threaten the financial system and require public bailouts.

Read full article as published in Bloomberg View.