Bank capital: how much is enough?

Tweaks to Basel III provoke warnings from US bankers

The biggest issue in US banking right now is the higher bank capital requirements proposed by the US regulatory authorities. These proposals, which would require banks to increase their capital by 20%, have agitated US bankers and prompted warnings that borrowing costs would increase.

In March 2023, global attention was fixed on the US banking system as several mid-sized regional banks succumbed to the devastating effects of unprecedented deposit runs. Things got especially interesting when Credit Suisse, the Swiss banking behemoth, teetered on the brink of collapse. The travails of a huge international bank naturally fuelled worries of contagion, reminiscent of the terrifying days in the autumn of 2008.

Fears of another global financial meltdown did not play out for two reasons. First, US authorities acted quickly to contain the nascent crisis, extending deposit insurance and injecting central bank liquidity. These measures prevented a further serious deterioration in confidence and, by backstopping the failing institutions, paved the way for their acquisition by stronger firms.

Second, bank capital ratios in March 2023 were significantly higher than in 2008. Those higher capitalisation ratios reflected the decision by international bank regulators and supervisors to bolster the system’s resilience. The Basel III rules – named for the Swiss city home to the Basel Committee on Banking Supervision – adopted in the wake of the 2008 financial crisis raised both capital and liquidity buffers for large internationally active banks.

The proposed final tweaks to Basel III are the reason US bankers are so agitated. However, their warnings are somewhat overblown.

Basel III capital and liquidity buffers protected the banks from the risk of contagion a year ago. In fact, the biggest banks saw their deposits increase as money fled smaller regional banks. Bankers point to this resiliency as evidence that existing capital requirements are sufficient. They might have a point except for those extraordinary policy measures to protect the economy from financial instability.

Moreover, bank capital is not tantamount to money locked away in a vault that can’t be lent out. When a bank raises capital by issuing shares or through retained earnings, it can use some of those funds to buy liquid assets, such as government treasury bills, and to lend as illiquid assets – home mortgages or car loans. If a bank wants to fund a certain level of lending, it can raise additional deposits or issue bonds, increasing debt. Alternatively, the bank can issue more shares or retain earnings, increasing its capital base.

From the bank’s perspective, capital is costly relative to debt because tax laws provide a financial incentive to issue debt in the form of interest deductibility. By increasing the share of debt in the capital structure of the firm, the bank’s managers can increase after-tax returns to shareholders.

In other words, higher capital requirements entail private costs – smaller bonuses for bank managers and less attractive returns for bank shareholders. And if the risk-adjusted return on bank capital is below the risk-adjusted return in other sectors because of higher capital requirements, banks would have more difficulty raising capital, leading them to ‘optimise’ their balance sheets, reducing the volume or raising the price of some lending, such as loans to disadvantaged clients.

The question is whether these private costs are offset by lower social costs as measured by a reduced risk of financial crises. Put simply, more capital reduces this risk because banks are better able to withstand large negative shocks.

While this trade-off underlies the Basel III rules, it doesn’t imply that banks should hold sufficient capital to withstand all conceivable shocks. It would have been foolish, for example, to force banks to have enough capital to withstand the financial market dysfunction that accompanied the onset of the Covid-19 pandemic – a truly ‘once-in-a-century’ shock that only government balance sheets, backed up by the financial firepower of central banks, could absorb. But short of black swan shocks, banks should be required to hold sufficient capital to prevent the kind of crisis created by imprudent risk-taking, as occurred in 2008.

Unfortunately, one year after the biggest banking crisis since the onset of the 2008 financial crisis, we still don’t have an answer to the key question regarding bank capital: how much is enough? That needs to change if we’re to prevent future financial crises.

James Haley is a Senior Fellow at the Centre for International Governance Innovation and a Canada Institute Global Fellow at the Woodrow Wilson Center for International Scholars.

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