More on Capital Requirements

This is going to be a running post on articles talking about the need for bank capital.

I will also be posting articles under the arguments for and against a strict bank capital requirement. Like any policy we need to understand the costs and benefits of added bank capital. The costs are reduced lending, the benefits are a reduced likelihood of a financial crisis. Here are the results from the Basel panel.

Here is recent article from the WSJ talking about recent moves toward more bank capital. Of course Citi Bank does not like the requirements.

Here is the first article from The Economist. This article talks about increased bank capital during the onset of the financial crisis.  How much capital is enough?

The Basel Accord has been an attempt to standardize bank capital requirements across countries. Here is an article talking about Basel III.

A panel discusses the effects of bank capital requirements on economic growth. The pros are simple, more capital reduces the likelihood of a bank become insolvent due to large loan write downs. The costs are simple, the more capital reduces the return on equity for bank owners.

I'm in favor of strict capital requirements for all bank-like institutions. I believe the financial system in a large way acts as a public good. Because of the problems posed by banks failing to fully account for the costs of risky behavior (yes, largely created by the types of regulations we currently have) large banks do not recognize the costs to society. I view capital requirements as an easy but highly effectively way of minimizing regulations while allowing banks to serve society (i.e. channeling funds from borrowers to savers). I like these requirements mainly because banks still have a choice for the types of assets they want to hold. If banks want to undertake in subprime lending they can, but it needs to be supported by added capital. Will this slow down growth, probably in the short run, but in the long run it will lead to fewer financial crises. Given the recent number of crisis that could have been avoid if banks were holding adequately capital, I view the long run benefits as a necessary.

Capital Requirements

I am a big proponent of increasing capital requirements (especially on banks that are deemed too big to fail). The World Bank produced a nice report summarizing capital requirements and leverage during the mid-2000s.  Here is a discussion in the Economist about capital requirements.

My preference for capital requirements would that they are increasing with the overall size of the balance sheet, riskiness of the assets held, and the greater the level of interest rate risk.

Here is a good article from the Economist supporting capital requirements:

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.