Do you hate bailing out big banks? Then you should love high capital requirements.
This week, U.S. financial regulators proposed raising such requirements, which force banks to take on less debt when buying assets.
My colleague Matthew Klein wrote yesterday about a solid economic argument: Low capital creates the systemic risk of insolvency, thereby incurring an external cost on taxpayers. The role of capital requirements and other banking regulations is to shift that cost back onto the banks, correcting their incentives on risk.
Klein is right, but there's an even stronger case to make. It comes from new paper by two economists for the Federal Reserve Bank of Minneapolis, V.V. Chari and Patrick J. Kehoe.
Governments have a hard time making credible pledges not to bail out banks, Chari and Kehoe write. Even though they want to, the governments simply can't convince anybody they won't renege in the moment. The problem is called "time inconsistency": Overall, it's better to have no bailouts; but, in crisis, a bailout becomes preferable to no bailout.
"The idea that the government has this unlimited ability to make such prior commitments is unrealistic and also has worked out badly when they tried," Chari told me in an interview. "To the extent that banks doubt the credibility of a no-bailout commitment, they have an incentive to take on lots of risk and then force the commitment to be broken."
Enter high capital requirements. They fix the time-inconsistency problem in three ways:
- They make it less likely that a bank needs a bailout. Stronger bank balance sheets reduce the risk of insolvency.
- They reduce the cost of letting banks go insolvent. More equity makes banks less domino-like. They can better absorb losses if counterparties fail.
- They increase the government's cost of breaking its no-bailouts commitment.
"In our model, the costs of a financial crisis come largely from resources lost in bankruptcy and liquidation," Chari said. "To the extent that capital requirements can reduce the debt level of firms, that reduces the losses from bankruptcy. And because it reduces the losses, it reduces the incentive of governments to bail out."
The only way to have banking without bailouts is make banks steel themselves against the risk of insolvency. There's no way to undo the 2009 bailout, but regulators can do something now to address time-inconsistent preferences for the years to come.
(Evan Soltas is a contributor to the Ticker. Follow him on Twitter.)