The U.S. Federal Reserve has taken an important step toward reducing the threat that many of the world's largest banks present to taxpayers and the economy. Unfortunately, the Fed and regulators around the world still have more to do.
The central bank approved a new rule that will require the country's largest banks to finance themselves with more equity capital -- which, as opposed to debt, can absorb losses and prevent insolvency in times of trouble. For each $95 they borrow, bank holding companies will need to have at least $5 in capital, enough to absorb a 5 percent decline in the value of their assets. This simple "leverage ratio" supplements the complex, risk-weighted capital requirements on which regulators have traditionally focused.
By making failures less likely, the rule will help reduce an implicit subsidy that the largest banks have been getting from taxpayers: Creditors lend to them more cheaply on the assumption that the government will bail them out in an emergency. The more such banks borrow for each dollar in capital, the more they benefit -- a perverse incentive that encourages them to take on the kinds of risks that can lead to disaster.
In a new report, the International Monetary Fund offers a sense of how much such subsidies to systemically important banks cost taxpayers every year. For the U.S., the IMF's estimates range from $15 billion to $70 billion for 2011 and 2012 -- an amount that accounts for a big chunk of the banks' profits. Add in the euro area, the U.K., Switzerland and Japan, and the range gets as high as $156 billion to $630 billion. The report notes that even the biggest number might be an underestimate.
With its new rule, the Fed has recognized that more demanding capital requirements are the best way to reduce the subsidy and make the banks safer. But the rule is still too timid. Capital ratios should be high enough to ensure that the banks' own shareholders -- rather than taxpayers -- will absorb whatever losses the banks might incur. Research and experience suggest that the right threshold would be higher than 5 percent, as in the Fed's new rule, and certainly higher than the 3 percent minimum set by global regulators in Basel and still binding in many countries outside the U.S.
Given the immense costs of financial crises, erring on the high side would be prudent. The point isn't that banks should avoid taking risks; taking risks is their business. The point is that taxpayers should no longer be on the hook when the risks turn bad.
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