With the Global Economy on its Knees, Regulators Seek Even Higher Bank Capital Requirements

A case of regulatory excess. Despite the thousands of pages of Dodd-Frank and Basel III that have resulted in an extensive new network of financial regulation and regulatory bodies (hello FSOC, CFPB, et al) since the crisis, global regulators are still not satisfied. Or perhaps like fading Hollywood celebrities, they feel their relevance slipping away as the global economies have bogged down and the financial markets have become rather tedious.

A recent Wall Street Journal article, World's Largest Banks to Be Forced to Hold Big Capital Cushions, reports that a new regulatory capital requirement for global systemically important banks (G-SIBs) has been proposed by the Financial Stability Board (FSB):

The world’s largest banks will have to hold 16% to 20% of their risk-weighted assets in equity and cancelable debt to shield taxpayers from big bills for bailing out failed banks during a crisis, according to a plan by global regulators published Monday.

Regulators see this rule as a way to put an end to the so-called “too-big-to-fail” problem—a crucial step in preventing bailouts for large lenders and shielding taxpayers from having to foot the bill for failing banks.

A few points, then we’ll move on to discussing bank capital:

1. I’m all for addressing the “unfinished business” of the financial crisis. Pretty much everyone realizes that both the regulatory response during the crisis, coupled with the expansive (and at times scattershot) post-crisis regulation, has done more to cement the idea of “too big to fail” than it has to abolish it. So ok, I get what they’re trying to do. But...
2.  Really? A seventh new (or higher) capital (or liquidity or collateral) ratio for banks to satisfy that will continue to put downward pressure on bank lending and wages GLOBALLY? Higher capital requirements are already being phased in, thanks to Basel III, and that’s not the only tool in the toolshed, right? If you want to make those capital requirements more meaningful, try standardizing the financial accounting rules first, so at least we don’t start by comparing apples to grapefruits.
3. For the last time, in the US the “financial bailout of the banks” did not cost the taxpayers one dollar. Of the roughly $250 billion of capital (nee taxpayer funds / TARP money) that was injected into the banks, over $280 billion in total was repaid (capital plus interest) within 5 years (and the bulk of it was repaid within 3 years). The US taxpayers made a profit of $30 billion on the “bank bailout”.

Ok, I’m done. Sort of. Here are the facts, with plenty of reference material linked.

What’s the FSB? The FSB was established in 2009 as a successor to the Financial Stability Forum. The FSB draws its membership from international finance ministries, supervisory agencies and central bankers from the G-20 countries. The purpose of the FSB is to assume a key role in promoting the reform of international finance regulation and global financial stability.The FSB – like the Bank for International Settlements (BIS) and its Basel Committee – lacks the authority to impose its recommended financial rules and standards, as there is no such global banking regulator (laws being mostly national, and all that). Instead, the FSB relies on the influence of their global members to incorporate their proposed rules into the financial regulatory framework in each country. Before you breathe a big sigh of relief (or high-five your buddy at the FDIC), the current head of the FSB is Mark Carney, also the governor of the Bank of England. The FSB certainly does not lack for influence over the regulatory policies of the G-20 nations.

The role of bank capital. The following is quoted from an excellent Primer on Bank Capital authored by Douglas Elliott of the Brookings Institution (formatting added, edited for brevity).

In its simplest form, capital represents the portion of a bank’s assets which have no associated contractual commitment for repayment. It is, therefore, available as a cushion in case the value of the bank’s assets declines or its liabilities rise.

Capital is intended to protect certain parties from losses, including depositors, bank customers, and bank counterparties. ... Common stock is the purest form of capital because there is no requirement to ever pay it back, nor is there a legal requirement to pay dividends. Common stock also has the lowest payment priority in bankruptcy, with the legal right only to receive any residual value after all other claimants are paid.

Bank capital requirements. Regulatory and ratings agencies both set a variety of capital requirements for banks. These capital requirements are usually expressed as a ratio of some definition of capital to assets:

                Capital* / Risk-weighted assets          or            Capital* / Total assets

where Capital* can be Tier 1 capital, Tier 2 capital, Total capital or – the newly proposed FSB capital classification – Total Loss Absorbing Capital (TLAC) which would be appear to be equity broadly defined plus cancelable debt (maybe that includes contingent capital? The standards are still in flux).  

For example, beginning in 2015 most banks minimum Tier 1 capital ratio has to exceed 6%. This is the ratio of Tier 1 Capital to risk-weighted assets. Tier 1 capital is the strictest definition of capital used by  regulators, and includes only common equity (paid-in capital and retained earnings) and non-cumulative perpetual preferred stock. As the definition of allowed capital expands, the required ratio of capital to assets increases.

More capital equals safer banks, and a safer banking system. When the financial crisis hit and banks, brokerages and other financial companies were struggling and failing left and right, most people agreed that (1) bank capital was too low, and (2) bank leverage was too high. (There is an important point to be made that neither Lehman or Bear failed due to lack of capital, but most of you are well aware of those circumstances so I’ll skip the obvious argument of regulatory overreach.)

Anyway. Financial regulators – adopting measures proposed in Basel III - increased a variety of bank capital requirements and introduced several new ones (e.g. the leverage coverage ratio, the liquidity coverage ratio) in the wake of the financial crisis to make the banking system safer. The phasing-in of increases in Tier1, Total Capital and the Capital Conservation Buffer are shown in a chart (slide 13 of 15) in from a great presentation by Emily Yang of the Federal Reserve bank of New York called Bank Capital and Regulation. )I tried to copy the image from pdf into my blog, but apparently I still a blog technology nitwit. Will try to update soon.)

The cost of capital varies by country and across the business cycle. The downside is that capital is very expensive for banks. Research from Michael R King, The cost of equity for global banks: a CAPM perspective from 1990 to 2009 published in the BIS Quarterly Review, September 2009:

One lesson drawn from the ongoing financial crisis is that banks should hold more common equity in their capital structure. Common equity is the first category of bank capital available to absorb losses; the greater this cushion, the more losses a bank can withstand while remaining financially viable. For this reason, common equity is also the most expensive form of bank capital, as investors expect to be rewarded for the greater risk they bear through some combination of dividends and capital appreciation.

Higher capital standards increase the operating costs of the bank, driving the cost of lending higher, compensation lower, and ultimately being a drag on economic growth. Below I briefly recap extensive research and commentary from the BIS, the aforementioned Douglas Elliott, and from the FSB itself on the potential impact of higher capital requirements.

Based on research from the BIS (paper cited above), the cost of equity to the bank varies by country and across the business cycle. King compares the cost of bank equity across six different countries and over time. King shows that the average cost of equity for banks in the 2002-2009 period varied from a low of 5.4% in Canada to a high of 11.2% in Japan. Furthermore the cost of equity decreased steadily in most countries except for Japan from 1990 to 2005 as real risk-free interest rates declined. Given that the cost of equity capital for banks is

(a) not equal across countries or among institutions within a single country;

(b) sensitive to the stage of the business cycle; and

(c) varies with real interest rates in a country,

it seems unpredictable at best to impose a “global standard” capital charge on banks.

The trade-off between bank safety and economic growth. Perhaps the bigger issue is that the potential impact of raising bank capital standards (again) is the chill it puts on bank lending, employee wages in the sector, and economic growth. From Douglas Elliott’s primer on bank capital (edited for brevity):

Higher bank capital requirements are likely to result in higher interest rates on loans, lower rates on deposits, and reduced lending. Higher capital levels increase the total expense of operating a bank and making loans, even taking account of the decrease in the cost of each dollar of bank equity and debt due to the greater safety of a bank which operates with more capital. This higher level of expense for the banking system can be offset in part by reducing other expenses, such as compensation and administrative expenses. However, the net effect is still likely to be negative, leading to a need to improve the net return on loans by turning down the least attractive loan opportunities, charging more for those that are taken on, and reducing deposit costs to increase the margin between the interest rates earned on loans and those paid for funding the loans.

The economic recovery in the US is already well under way, though we are clearly on a lower growth, lower wages, lower inflation trajectory for the time being. The US banking system could probably absorb the additional cost of capital, though the downstream effect would almost certainly be to push more financial intermediation and lending – particularly to weaker credits – outside of the banking system. But what about Europe (ex the UK) and Japan? Do you really want to put pressure on any regulatory lever that will contribute drag to their economies?