Higher Capital Requirement May Be Privately Costly to Banks, But Their Financial Stability Benefits Come at a Near Zero Cost to Society
In general, I am a fan of Greg Ip. So I was disappointed to see him falling into accepting the bank lobbyists’ line that higher capital requirements are bad for the economy. In fact, higher capital requirements cut into bank profits but improve financial stability at no cost to society as a whole. The cost to bank profits is made up for by less chance of taxpayers being left holding the bag on large losses.
Banks see debt as a less expensive way to raise funds than equity, but the costs of raising funds by equity better reflects the true risks the banks are engaging in and so gives the right incentives. Raising funds by “equity” means not only issuing stock but also retaining earnings that a bank can then lend out. The advantage of pushing banks toward raising funds by raising equity is that when things go badly, equity starting from a high value can drop quite a bit without causing any trouble for the smooth operation of the bank. The value of stock goes down, but the bank doesn’t go bankrupt. Just as importantly, others dealing with the bank— “counterparties”—don’t worry that they will be stiffed if the bank goes bankrupt. Without a bankruptcy, stock prices going down cause zero problems for counterparties.
Bank debt can be too cheap for banks for three reasons. First, there is an unjustified tax advantage to debt because interest payments are more tax deductible than dividend payments are. Second, when banks go bankrupt there is always the chance that the government will bail them out. From the bank’s perspective, having a shot at bailout money depends on having enough debt to go bankrupt when things go bad instead of just having stock prices go down. The government almost never bails banks out simply because their stock price has gone down without bankruptcy. Third, some households and institutions may pay a premium for the illusion of safety even if the supposed safety isn’t real. (Institutions don’t necessarily have to be fooled to want the illusion of safety; regulations sometimes ask them to obtain the illusion of safety.)
On the third point of the demand for the illusion of safety, there is a very interesting paper by Robin Greenwood, Samuel Hanson and Jeremy Stein that was presented at Jackson Hole, “The Federal Reserve's Balance Sheet as a Financial-Stability Tool,” that basically argues that the Fed or the Treasury needs to offer plenty of very safe short-term assets so that the strong demand for such assets doesn’t cause the private market to create the illusion of very safe short-term assets. In addition to the importance of this for financial stability benefits, this also indicates that the social cost of discouraging banks from issuing these illusions is low because any advantage banks could get from issuing such assets at low interest rates points to the benefits to the government budget from the government issuing the genuinely safe short-term assets at low interest rates.
In Greg Ip’s Wall Street Journal article shown above, “Fed’s Reversal on Bank Capital Requirements Serves No Purpose,” there is a red herring. Greg talks as if bank equity is a cushion against losses asset by asset and therefore serves no purpose when a formula makes a bank get more total funds from equity when it has more assets even if the extra assets are all government promises that are quite safe. But bank equity is a cushion for all of a bank’s assets put together and few banks have 100% safe assets. If a formula makes a bank get more funds from equity to back more assets even if those assets are safe, then that equity is available to cushion losses from the risky assets the bank has along with the safe assets. It is perfectly reasonable to say that the formula should have required more equity for each unit of risky assets because that would be better targeted. But when bank lobbyists have made capital (=equity) requirements mandated directly for risky assets too low, the extra capital (=equity) forced by the formula based on total assets (including safe assets) may get capital (=equity) a little closer to where it should have been for the typical bank.
But the more powerful argument is that there is no harm done from requiring banks to have a lot of capital. Any hit to their profits is made up for by the taxpayers doing better, and the incentives of the banks become better aligned with the true risks to society. If there is any tendency toward too little aggregate demand in the economy, the right answer is monetary stimulus. (See “Why Financial Stability Concerns Are Not a Reason to Shy Away from a Robust Negative Interest Rate Policy.”) If there is any tendency toward too little risky investment even when unemployment is low, the right answer is sovereign wealth fund investing in exchange-traded funds financed by issuing Treasury bills to narrow the risk premium. (See “Alexander Trentin Interviews Miles Kimball about Macroeconomic Stabilization: Negative Rates and Sovereign Wealth Funds” along with the links it features.)
One other red herring is banks’ claims that capital requirements like the ones the Fed is restoring prevent them from lending out money. But capital requirements only say where the money comes from, not where it goes. Once a bank has gotten money from issuing stock, it can lend it out as much as it wants. Risk-weighted capital requirements do more to discourage lending (which is risky) than capital requirements based simply on total assets. Also, if banks were that worried about having funds to lend out, they shouldn’t be so eager to pay dividends to shareholders when retained earnings that keep their capital (=equity) levels strong give them more total funds to lend out. In any case, banks having too little money to loan out sounds like an aggregate demand problem. Aggregate demand is not scarce for a central bank willing to use negative interest rates as central banks should. (See “How and Why to Eliminate the Zero Lower Bound: A Reader’s Guide.”)
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