The Federal Reserve, according to reports, has decided that big U.S. banks will have to comply with an emerging new global rule on capital. It’s a move the banks have fought, arguing that it will increase their costs and discourage lending.
If they are about to lose this argument, that’s good news. The new rule isn’t too demanding. It’s not demanding enough.
Under the proposed new Basel framework, all banks will have to raise more capital than before: a minimum 4.5 percent of risk-weighted assets (plus a 2.5 percent capital conservation buffer), against 2 percent previously. In addition, eight U.S. banks, and 21 others elsewhere, have been deemed systemically important -- meaning that their failure would threaten the wider financial system. They might have to raise as much as an extra 2.5 percent.
This is too strict, say the banks. Capital in the form of equity is expensive to raise, they say, so requiring more of it will make lending less profitable and shrink the supply of credit. Governments really ought to make up their minds, say the banks. With economies still weak, regulators should be encouraging new lending -- and here they are, about to do the opposite.
The banks’ case is superficially plausible thanks to a popular fallacy: the idea that equity sits idle and unused on a bank’s balance sheet as a kind of overhead. In fact, equity is just another source of funds. The proceeds from a sale of equity can be lent out or applied to other purposes just as readily as proceeds from, say, taking a deposit.
The all-important difference is that equity can absorb losses, whereas deposits have to be repaid in full. Thanks to that loss-absorbing capacity, the more equity a bank has, the less likely it is to fail. Selling additional equity does not constrain the amounts of other funds it can access or the amount of lending it can do.
Shareholders do have to be paid a return -- so perhaps the banks are right that being forced to raise more capital would raise their cost of funding? On the face of it, no. A bank with more equity is a safer bank, so the required rate of return on its equity will be lower. Standard financial theory tells us that altering the mix of equity and other instruments changes the way risk and return are spread around, but not the overall cost of funding.
Many academic studies have rebutted the banks’ argument. A much-cited paper by Stanford’s Anat Admati and colleagues -- “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity Is Not Expensive” -- should have ended this debate once and for all. It dismantles the banks’ position step by painstaking step.
The study makes the crucial distinction between the interests of bank managers, bank shareholders and the public at large. Managers are being disingenuous. They do have reasons, valid after a fashion, for opposing higher capital requirements, just not reasons they can admit. The one they emphasize -- cost of funding and its effect on future lending -- is fit for public use, but bogus.
What might their real reasons be? If banks sell more shares, it’s true that the return on equity will fall. If managers’ pay is tied to return on equity (as it often is), they will be worse off. Shareholders, on the other hand, shouldn’t mind, because the risk of their investment is reduced in proportion. Taxpayers, of course, would be better off -- less likely to be stuck at some point with the cost of bailing out the bank.
In other ways, the undeclared interests of bank managers and shareholders are aligned. The U.S. tax code, for instance, strongly discriminates in favor of debt and against equity. (Interest payments are a deductible business expense, whereas dividends and capital gains are taxed.) If you force banks to raise more equity, you reduce the value of this implicit subsidy.
No More Handouts
Curbing the benefits of both kinds of subsidy -- the tax preference granted to debt, and the likelihood of a bailout if the bank fails -- would be bad for bank shareholders and managers and good for taxpayers. So let’s be clear: What banks really dislike about the proposed new rule is that it limits their access to handouts from the rest of us. You can understand their reluctance to say so.
If the new rule on capital is not too strict, how much stricter should it be? On this I recommend another study: “Optimal Bank Capital,” by David Miles and colleagues at the Bank of England. This paper starts by listening politely to the banks’ arguments and bends over backward to recognize ways in which higher capital requirements might after all raise banks’ cost of funding.
It then considers a base case -- generous, I think, to the banks’ view of the matter -- in which a doubling of capital increases the banks’ cost of funding 0.2 percentage points. The researchers estimate that this would raise the cost of capital for the wider economy by less than a tenth of a percentage point. Long-term gross domestic product would fall, as a result, by between 0.1 and 0.2 percent.
In return for this tiny reduction in output, a doubling of bank capital would cut the risk of a financial breakdown that could potentially cause vastly more damage. Nobody should need reminding how bad the downside risk can be. A financial collapse can cut GDP by 10 percent or more in the short term, with long-lasting or even permanent effects.
Weighing probabilities, Miles and his colleagues look at a series of simulations, searching for the capital ratio that minimizes the overall cost. Converting their numbers to Basel definitions, they recommend a ratio of 20 percent of risk-weighted assets, more than double what is currently proposed.
The banks call that unthinkable. I call it the lower end of what makes sense. Pay no attention to the bankers’ complaints. The new Basel rule is no more than a modest step in the right direction.
(Clive Crook is a Bloomberg View columnist. The opinions expressed here are his own.)
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