Bank capital requirements are the focus of contentious and heated debates. Since they limit banks’ ability to take on risk and leverage, owners and managers almost always argue for lowering them. To reduce the likelihood of using public funds for further bailouts, both libertarians and progressives argue strenuously that they should be higher. Focusing on the balance between the social benefits of a more resilient financial system and the social costs of curtailing liquidity and loan provision, academicians usually conclude that current levels are too low. So, with well-financed banks and their lobbyists on one side, and a cohort of advocates armed with academic research on the other, regulators are caught in the middle. To whom should they listen?

The answer to this question is an empirical one, so it is important to base any conclusions on a fair and balanced reading of the evidence. Regular readers of this blog will be unsurprised that we continue to maintain that bank capital requirements should be higher than they were even before the Federal Reserve started began its stealth campaign to relax them several years ago. If we were to pick a number, we would start with a leverage ratio—the ratio of common equity to total assets (including off-balance sheet exposures)—that is in the range of 10 to 15 percent, and possibly higher. The risk-weighted equivalent would be about twice as high in the United States (or three times as high in Europe). (The exact numbers depend on the intricacies of accounting standards.) The one thing we would not be arguing for is a further erosion of capital requirements from their current level.

We start with a short reminder about why we need capital requirements in the first place….

On the Resilience of Large U.S. banks

In the aftermath of the financial crisis of 2007-09, policymakers were intent on making the financial system able to weather an extremely severe storm. The authorities had two complementary goals: increase the financial system’s reliance on equity financing and enhance the ability of institutions to recapitalize themselves after a shock. Well, COVID-19 is upon us, and the shock looks to be bigger than the most adverse scenarios in supervisory stress tests.

Our view is that we have made limited progress in promoting resilience. In a recent post, we emphasized how COVID-19 economic disruptions are eroding banks’ capital buffers (that already were slim in parts of Asia and Europe). As the full impact economic and financial impact of COVID 19 becomes apparent, we suspect that some banks will need a form of recapitalization. They were not able to do this in 2008-09 on their own. Will this time be different …?

What Risk Professionals Want

As memories of the 2007-09 financial crisis fade, we worry that complacency is setting in. Recent news is not good. In the name of reducing the regulatory burden on small and some medium-sized firms, the Congress and the President enacted legislation that eased the requirements on some of the largest firms. Under the current Administration, several Treasury reports travel the same road, proposing ways to ease regulatory scrutiny of large entities without changing the law (see here, here and here). And, recently, the Federal Reserve Board altered its stress test in ways that make it more likely that poorly managed firms will pass. It also voted not to raise capital requirements on systemically risky banks over the next 12 months.

A few weeks ago, one of us (Steve) had the privilege to speak at the 20th Risk Convention of the Global Association of Risk Professionals (GARP). Founded in 1996, GARP engages in the education and certification of risk professionals and has several hundred thousand members worldwide. (Disclosure: Brandeis International Business School and NYU Stern are GARP Academic Partners.) The organizers allowed us to solicit the views of the 100-plus attendees on two issues that are central to financial resilience: Are bank capital requirements high enough? And, do central counterparties (CCPs) have sufficient loss-absorbing buffers? They answered both questions with a resounding “NO” ….

Improving resilience: banks and non-bank intermediaries

Debt causes fragility. When banks lack equity funding, even a small adverse shock can put the financial system at risk. Fire sales can undermine the supply of credit to healthy firms, precipitating a decline in economic activity. The failure of key institutions can threaten the payments system. Authorities naturally respond by increasing required levels of equity finance, ensuring that intermediaries can weather severe conditions without damaging others.

Readers of this blog know that we are strong supporters of higher capital requirements: if forced to pick a number, we might choose a leverage ratio requirement in the range of 15% of total exposure (see here), roughly twice recent levels for the largest U.S. banks. But as socially desirable as high levels of equity finance might be, the fact is that they are privately costly. As a result, rather than limit threats to the financial system, higher capital requirements for banks have the potential to shift risky activities beyond the regulatory perimeter into non-bank intermediaries (see, for example here).

Has the increase of capital requirements since the financial crisis pushed risk-taking beyond the regulated banking system? So far, the answer is no. However, in some jurisdictions, especially the United States, the framework for containing systemic risk arising from non-bank financial institutions remains inadequate….

Liquidity Regulation is Back

Modern bank regulation has two complementary parts: capital and liquidity requirements. The first restricts liabilities given the structure of assets and the second limits assets based on the composition of liabilities.

While capital regulation―especially in its risk-based form―is a creation of the last quarter of the 20th century, liquidity regulation is much older. In fact, the newly implemented liquidity coverage ratio (LCR) harks back to the system in place over 100 years ago. In the United States, before the advent of the Federal Reserve in 1914, both national and state-chartered banks were required to hold substantial liquid reserves to back their deposits (see Carlson). These are the reserve requirements (RR) that remain in effect in most jurisdictions today, the United States included.

In this post, we briefly examine the long experience with RR as a way to gain insight regarding the LCR. We draw two conclusions. First, we argue strongly against using the LCR as a monetary policy tool in advanced economies with well-developed financial markets. Like RR, it is simply too blunt and unpredictable. Second, for the LCR to work as a prudential policy tool, it should probably be supplemented by something like a fee-based line of credit at the central bank....

Bank Financing: The Disappearance of Interbank Lending

Retail bank runs are mostly a thing of the past. Every jurisdiction with a banking system has some form of deposit insurance, whether explicit or implicit. So, most customers can rest assured that they will be compensated even should their bank fail. But, while small and medium-sized depositors are extremely unlikely to feel the need to run, the same cannot be said for large short-term creditors (whose claims usually exceed the cap on deposit insurance). As we saw in the crisis a decade ago, when they are funded by short-term borrowing, not only are banks (and other intermediaries) vulnerable, the entire financial system becomes fragile.

This belated realization has motivated a large shift in the structure of bank funding since the crisis. Two complementary forces have been at work, one coming from within the institutions and the other from the authorities overseeing the system. This post highlights the biggest of these changes: the spectacular fall in uncollateralized interbank lending and the smaller, but still dramatic, decline in the use of repurchase agreements. The latter—also called repo—amounts to a short-term collateralized loan....

Basel's Refined Capital Requirements

After nearly a decade of negotiations, last month, the Basel Committee on Banking Supervision completed the Basel III post-crisis reforms to capital regulation. The final standards include refinements to: credit risk measurement and the computation of risk-weighted assets; the calculation of off-balance-sheet exposures and of the requirements to address operational risk; and the leverage ratio requirement for global systemically important banks (G-SIBs).

In this post, we focus on revisions to the way in which banks compute risk-weighted assets. To foreshadow our conclusion: the new approach adds unnecessarily to regulatory complexity. If the concern is that current risk-based requirements result in insufficient capital, it would be better simply to raise the requirements.

Ending Too Big to Fail

More than six years after the Dodd-Frank Act passed in July 2010, the controversy over how to end “too big to fail” (TBTF) remains a key focus of financial reform. Indeed, TBTF—which led to the troubling bailouts of financial behemoths in the crisis of 2007-2009—is still one of the biggest challenges in reducing the probability and severity of financial crises. By focusing on the largest, most complex, most interconnected financial intermediaries, Dodd-Frank gave officials a range of crisis prevention and management tools. These include the power to designate specific institutions as systemically important financial institutions (SIFIs), a broadening of Fed supervision, the authority to impose stress tests and living wills, and (with the FDIC’s “Orderly Liquidation Authority”) the ability to facilitate the resolution of a troubled SIFI. But, while Dodd-Frank has likely made the U.S. financial system safer than it was, it does not go far enough in reducing the risk of financial crises or in ensuring credibility of the resolution mechanism (see our earlier commentary here, here and here). It also is exceedingly complex.

Against this background, we welcome the work of the Federal Reserve Bank of Minneapolis and their recently announced Minneapolis Plan to End Too Big to Fail (the Plan). While the Plan raises issues that require further consideration—including the potential for regulatory arbitrage and the calibration of the tools on which it relies—it is straightforward, based on sound principles, and focuses on cost-effective tools. In this sense, the Plan represents a big step forward...

Brexit Stress Test

The U.K. Brexit referendum is providing us with the first significant test of our sparkling new regulatory system. Everyone knew about the referendum months in advance, giving them plenty of time to prepare. Yet, we are left with some fundamental questions related to global financial stability. Do banks have sufficient capital and liquidity to withstand the “shock?” Will financial markets continue to serve their key functions? Or, is the financial system only as strong as its weakest link? Will turmoil once again prompt liability holders to run, triggering asset fire sales, and compelling central banks once again to do whatever it takes to keep avert a meltdown?

As the rating agencies might say, we are on “stress watch” with a negative outlook. Or, to mix metaphors, numerous lights are flashing yellow, so we are worried...

Global Finance Requires More Global Cooperation

“We have listened to the wisdom of an old Russian maxim, doveryai, no proveryai—trust, but verify.” President Ronald Reagan at the signing of the INF Treaty, December 8, 1987.

In July 2010, central bank governors and supervisors from the 28 jurisdictions that make up the Basel Committee membership were hammering out the agreement on new capital and liquidity requirements now known as Basel III. There was a large sticking point. Some members were standing firm on their desire to have higher capital requirements. Others felt that this would make credit more expensive and less plentiful.

Had agreement not been reached, those insisting on more capital might have said: “Go ahead, be permissive. But if you let your banks operate with low levels of capital, we’ll restrict our banks from doing business with them.” Fortunately, it didn’t come to that....

Commentary

Money, Banking, and Financial Markets