Two numbers stand out. First, the short-term cost of tougher rules is fairly low: assuming a three-percentage-point increase in capital ratios and a four-year implementation period, absolute GDP would be just 0.6% lower than it would otherwise have been. Second, and offsetting the first effect, once the new rules are in place the benefits from having fewer crises are big. In a base case and assuming a three-percentage-point capital-ratio increase, the absolute level of GDP rises by some 1.7%.
Over the last three years there has been tremendous attention into financial reform. A major theme in our class will be discussing the role financial markets play in the economy and how to go about regulating these markets. Recently the US passed the Dodd-Frank bill which attempts to prevent future financial crises. Unfortunately, one area the bill fails to address is the need for bank capital requirements. Before getting into the gory details it may help to provide a brief side note on the role of bank capital.
Like any firm banks have assets and liabilities. Asset include loans made to households and business and government bonds. Liabilities include demand deposits (checking accounts) IRAs, and CDs, basically our accounts with banks. Bank capital is the difference between assets and liabilities. It shows up on the liabilities side of the balance sheet.
Banks prefer to not hold excess capital, they would prefer to pass the capital onto the owners in the form of equity or use the funds to create more loans. Nonetheless capital helps banks insurance against large loan losses. Remember loans (notably housing and commercial loans) appear on the asset side of the balance sheet, when banks experience large loan losses the asset side of the balance sheet decreases. If loan losses are large enough bank assets could become less than liabilities making the bank insolvent (i.e. the bank fails). Now because bank capital is a liability it helps offset loan losses.
Suppose you have two banks (A and B). Bank A has $100 million in capital and Bank B has $25 million. Each bank experiences large loan losses and writes down their assets by $50 million. Bank A will be left with $50 million in capital but Bank B will be insolvent with a net worth of -$25 million. If we go back 2 years, banks that failed lacked sufficient capital to insure against large loan losses.
Jump ahead to today and we still have not solved the bank capital requirements. Wall Street has argued against capital requirements, forcing banks into holding added capital will sufficiently hamper lending. I firmly believe we need to institution capital requirements based on three components:
1) The size of a bank's balance sheet. If mega banks pose added risk to the economy we need to force them into holding more capital.
2) The composition of a bank's assets. If banks want to hold riskier assets (i.e. subprime mortgages) we need to require greater capital requirements.
3) The composition of a bank's liabilities. If a bank has liquid liabilities (i.e. dependent on short-term financing) they are more prone to experience a bank run and a loss of funding, holding greater levels of capital will temper this threat.
The basis for my argument comes from the last 20 years of banking crises. We have seen large financial crises occur in Asian, Latin America, Scandinavia, and now the United States. In nearly every case banks did not hold sufficient amounts of capital. The solution to our financial crisis was to inject major banks with added capital (remember TARP). If banks were holding sufficient capital we could have prevented needing to bailout nearly every large bank.
Of course there was a fear of a large slowdown in global growth. Well, it turns out the costs of financial crises trumps the reduction in growth from a slowdown in banking lending. Banks would be forced into more due diligence when issuing loans and likely choose safer investments.