By John Dearie

Executive Summary

Since the 2008 financial crisis, financial regulators have required large banking companies to hold higher and higher amounts of capital.  Most recently, on November 10th, the Financial Stability Board (FSB) issued a proposal that would require large banks to hold “total loss absorbency capacity” equal to 16 to 20 percent of their risk weighted assets – at least twice the minimum Basel III total regulatory capital ratio of 8 percent.

Mark Carney, FSB chairman and Governor of the Bank of England, said of the plan: “[O]nce implemented, these agreements will play important roles in enabling globally systemic banks to be resolved without recourse to public subsidy and without disruption to the wider financial system.”

To be sure, sufficient loss-absorbing capital is a critical aspect of any bank’s health and stability.  But calls for ever higher capital overlook the significant system-strengthening progress made to date, as well as the reality that additional capital is not without costs or consequences.

In the following ForumBlog post, “More Capital: Everyone’s Favorite Imperfect Solution,” Forum Executive Vice President for Policy John Dearie explains the following:

  • The capitalization of U.S. banks has dramatically improved since the financial crisis, as overall capital is currently at or near record levels, and improvements in many other important areas have significantly reduced banks’ overall risk profiles.

Capital chart

  • Too much capital can impede banks’ ability to perform their important role in fostering economic growth and job creation by limiting the supply of credit that American households, consumers, and businesses need.
  • An overreliance on capital as a kind of supervisory silver bullet can lull policymakers and regulators into a false sense of security, distracting them from other equally relevant aspects of safety and soundness.
  • Worst of all, excessive capital can become perverse – potentially incentivizing greater risk-taking by banks.

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More Capital: Everyone’s Favorite Imperfect Solution
By John Dearie
Executive Vice President for Policy, Financial Services Forum

In August of 2012, Senators Sherrod Brown (D-OH) and David Vitter (R-LA) sent a letter to Federal Reserve Chairman Ben Bernanke stating that announced changes to regulatory capital requirements – which quadrupled minimum capital requirements for the largest banks – are “far too low.”  More capital, the Senators wrote, “is a common sense way to fix the dangers of too-big-to-fail,” and, therefore, required capital should be set at levels that will “either incent [the largest banks] to become smaller or will help to ensure they can weather the next crisis without another taxpayer bailout.”

In early September of this year, Federal Reserve Board Governor Dan Tarullo announced during testimony before the Senate Banking Committee that the Fed would soon require large U.S. banks to hold a capital surcharge higher than the surcharge already imposed by the Basel Committee on Banking Supervision: “By further increasing the amount of the most loss-absorbing form of capital…we intend to improve the resiliency of these firms,” Tarullo stated.  “This measure might also create incentives for them to reduce their systemic footprint and risk profile.”

The week before, the Fed and the other U.S. banking agencies approved a final rule that modifies a key capital ratio – the supplementary leverage ratio – which will require large U.S. banks to maintain a ratio of capital to total assets at least 2 percentage points higher than the 3 percent minimum imposed by the Basel Committee.  The modified rule, Governor Tarullo explained in his Senate testimony “complements the agencies’ adoption in April of a rule that strengthens the internationally agreed-upon Basel III leverage ratio as applied to U.S.-based global systemically important banks (G-SIBs).”

Most recently, on November 10th, the Financial Stability Board (FSB) – an international body that monitors and makes recommendations regarding the global financial system on behalf of G-20 nations – issued a consultative document that defines a global standard for minimum amounts of “total loss absorbency capacity” (TLAC) to be held by G-SIBs.  The FSB’s proposal would require G-SIBs – a group that includes eight of the largest U.S. banking companies – to hold a minimum amount of regulatory capital, plus long-term unsecured debt, equal to 16 to 20 percent of their risk weighted assets – at least twice the minimum Basel III total regulatory capital ratio of 8 percent.  The FSB would also require that banks’ combined regulatory capital and long-term debt amount to at least 6 percent of banks’ total assets – at least twice the Basel III leverage ratio.  In addition to this “Pillar 1” requirement, TLAC would also include a subjective component (“Pillar 2”) to be assessed for each bank individually, based on qualitative bank-specific risks that take into account a bank’s recovery and resolution plans, systemic footprint, risk profile, and other factors.

Capital, it appears, is king.  Since capital protects banks from losses, the thinking goes, more and more capital will make banks safer and safer, and bank failures – and potential bail-outs – less likely.  And because capital isn’t free, some contend, higher required capital will also discourage big banks from growing bigger, and might even incentivize already large banks to downsize.

To be sure, a heightened focus on capital is entirely appropriate.  A bank’s capital is the simple difference between the value of its assets and the value of its liabilities – the bank’s net worth.  Typically comprised of investor equity, retained earnings, and various types of debt obligations, capital serves the important economic purpose of providing a buffer or cushion against which unexpected losses can be absorbed without jeopardizing the bank’s viability.  Sufficient loss-absorbing capital is a critical – not just important, but critical – aspect of any bank’s health and stability.  All else being equal, a bank holding more capital is stronger and more stable than a bank holding less.  And it is certainly true that many banks held too little capital before the recent financial crisis.

But it is also true that capital is not a silver bullet solution to the challenge of ensuring financial stability.  In fact, unnecessarily high levels of capital can become problematic and even counterproductive.

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Since the 2008 financial crisis, the capital position of U.S. banks has dramatically improved.  On March 24th the Federal Reserve announced the results of the latest “stress-test” exercise mandated by the Dodd-Frank Act.  The test imposed on the 30 largest bank holding companies a “severely adverse” crisis scenario that included deep recessions in the United States, Europe, and Japan; the U.S. unemployment rate soaring to 11.25 percent; stock prices dropping nearly 50 percent; and housing prices falling more than 25 percent.[1]

Among other important improvements, the stress test showed that tier 1 common equity capital – money provided by banks’ shareholders and the highest loss-absorbing form of capital – has more than doubled, from $460 billion in 2009 to $971 billion as of year-end 2013.  The additional capital has raised the aggregate tier 1 common equity ratio, which compares high-quality loss-absorbing capital to risk-weighted assets, from 5.5 percent in the first quarter of 2009 to 11.6 percent in the fourth quarter of 2013.

Capital chart

The stress test results demonstrated that 29 of the 30 bank holding companies would not only survive the extreme crisis scenario, but maintain capital ratios above regulatory minimum levels.  “With each year we have seen broad improvement in the industry’s ability to assess its capital needs under stress and continuing improvements to the risk-measurement and -management practices that support good capital planning,” Fed Governor Tarullo said in a statement.

It’s also important to emphasize that the dramatic improvement in banks’ capitalization has been achieved even as banks have made other improvements that have significantly reduced their overall risk.  For example, liquidity has dramatically improved, with large banks more than doubling their holdings of cash and liquid securities since 2009.  Leverage has been reduced, in some cases cut in half.  Asset quality is far stronger, with noncurrent loan balances and charge-offs falling to pre-crisis levels.  Risk management, internal controls, and governance procedures have been significantly enhanced.  And compensation structures at most banks have been reformed to closely align the personal incentives of bank employees with the long-term performance and safety and soundness of the employing institution.  Together with near record levels of capital, such improvements make for a far healthier and more stable banking system.

This remarkable progress notwithstanding, calls for even higher capital continue.  The “more capital” reflex not only minimizes the significance of progress made to date, it also overlooks the reality that additional capital is not without costs or consequences – and can become counterproductive and even dangerous.

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For example, too much capital can obstruct banks’ ability to perform their critical role in the economy by limiting lending capacity.  Economic growth and job creation suffer if credit is scarce.  While it’s true that no bank ever failed from holding too much capital, an overcapitalized bank is just a pile of idle money – like a plane that never gains altitude.  Moreover, an underperforming economy due to insufficient credit availability ultimately undermines banks’ safety and soundness by impairing asset quality and earnings.

An overreliance on capital as a kind of supervisory silver bullet can also lull policymakers and regulators into a false sense of security, distracting them from other equally relevant aspects of safety and soundness.  Capital is a central aspect of banks’ well-being, but only one of many.  Other critical factors include the nature and quality of a bank’s assets, the rigor and effectiveness of its risk management framework, the soundness of its internal controls and governance procedures, the quality and diversity of its earnings, and the reliability of its liquidity position.  All these factors, considered together, and in relation to one another, determine overall safety and soundness.  Indeed, considered in isolation, outside the context of other essential aspects of safety and soundness, a particular capital level has limited meaning or supervisory value.

A quick, if somewhat silly, example:

If I told you that John weighs 175 pounds, could you say whether John’s weight is healthy?  That weight sounds reasonable, and would be if the John being discussed is me – 50 years old and six feet tall.  But 175 pounds would not be appropriate if the John in the example is my father, who is 6 feet, five inches tall.  And it would be extremely unhealthy if the John in question were my 8 year-old son.  Without knowing other relevant aspects of John’s physical circumstances, the fact that he weighs 175 pounds tells you very little about his overall well-being.

Worst of all, excessive capital can become perverse – potentially incentivizing greater risk-taking by banks.  Higher and higher levels of capital erode banks’ return on equity (ROE), a key measure of profitability and an important capital allocation metric used by investors.  An analysis by Bloomberg Government estimated that had the Basel-mandated capital surcharges been imposed on the largest U.S. banks as of the fourth quarter of 2011, their average ROE would have been reduced by 10.3 percent.[2]  As ROE declines, banks’ ability to attract the additional capital from investors that regulators are requiring becomes more and more difficult.  At some point, generating the higher returns necessary to attract additional capital from investors would require taking greater risk.

Capital is important.  Capital is critical.  But as is the case in many other contexts, too much of a good thing can be bad.  The capitalization of U.S. banks has dramatically improved since the financial crisis.  Overall capital is currently at or near record levels, and improvements in many other important areas have significantly reduced banks’ overall risk profiles.

Rather than indulging in overkill to the detriment of economic growth and job creation, let’s capitalize on the progress achieved to date by allowing banks to do what they’re intended to do – propel economic growth and job creation by supplying the credit that American households, consumers, and businesses need.


[1] “Dodd-Frank Act Stress Test 2014: Supervisory Stress Test Methodology and Results,” Federal Reserve Board of Governors, March 2014.

[2] “Why More Capital Means Lower Return on Equity for Largest U.S. Banks,” Bloomberg Government, Christopher Payne, March 7, 2012.