The regulatory reforms that followed the financial crisis of 2007-09 created a financial system that is far more resilient than the one in place 15 years ago. Yet, the events of March 2023 make clear that the progress thus far is simply not enough. To ensure resilience, we need to do more.
To steer the process of further reform, we propose a set of 10 precepts that those who make the rules should keep in mind as they refine the prudential framework. These practical guidelines lead us to conclusions that mirror those in a recent post: regulation should be more rule-based (less reliant on supervisory insight or discretion); simpler and more transparent; stricter and more rigorous; and more efficient in its use of resources. Concretely, this approach means increasing capital and liquidity requirements; shifting to mark-to-market accounting; and improving the transparency, flexibility and severity of capital and liquidity stress tests.
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….
Over the past 40 years, U.S. capital markets have grown much faster than banks, so that banks’ share of credit to the private nonfinancial sector has dropped from 55% to 34% (see BIS statistics here). Nevertheless, banks remain a critical part of the financial system. They operate the payments system, supply credit, and serve as agents and catalysts for a wide range of other financial transactions. As a result, their well-being remains a key concern. A resilient banking system is, above all, one that has sufficient capital to weather the loan defaults and declines in asset values that will inevitably come.
In this primer, we explain the nature of bank capital, highlighting its role as a form of self-insurance providing both a buffer against unforeseen losses and an incentive to manage risk-taking. We describe some of the challenges in measuring capital and briefly discuss a range of approaches for setting capital requirements. While we do not know the optimal level of capital that banks (or other intermediaries) should be required to hold, we suggest a practical approach for setting requirements that would promote the safety of the financial system without diminishing its efficiency....
Walter Wriston, Citicorp’s chief for nearly two decades until 1984, used to argue that banks’ didn’t need much, if any, capital. The global financial crisis put that view to rest. Today, we know that if banks are going to be able to absorb large unforeseen losses that would otherwise threaten financial stability, they need to finance themselves with equity, not just debt.
But how much capital do banks need to have to ensure the financial system is safe? Even after the financial crisis, answers to this question range widely, making it the single most contentious source of debate among bankers, regulators, and academics...
