What happens when banks are required to hold more capital?

Why shouldn't banks be allowed to go bust?

Financial regulation imposes requirements on banks to hold certain amounts of capital. When the financial crisis began in 2007, the capital banks held fell significantly. Regulators could have taken the view that capital is there as a buffer against a rainy day, and the rainy day had come, so the buffer should be allowed to be used up – indeed, if it were totally used up, the banks might go bust, as would be right and proper.  Instead, regulators tended to maintain their rules, so that if banks’ capital had fallen below the regulatory thresholds they were required to raise additional capital. From September 2008, as the crisis escalated after the quasi-nationalisations of US mortgage firms Fannie Mae and Freddie Mac, which triggered the collapse of a number of other institutions (most notoriously Lehman Brothers), regulators actually increased their capital requirements, so banks had to hold more capital on the rainy day than they had had to hold against the rainy day!

Subsequently, there have been many proposals that capital requirements should be increased even further.  A rather odd (and badly confused) idea has emerged, particularly amongst politicians but also certain regulatory authorities, that the point of capital requirements is to prevent banks going bust. It certainly is not. Capital requirements would have to be many many times their previous levels even to have a significant impact on when banks would go bust – at levels that would be considered implausible by almost anyone – and even then there would still be some occasions, every few decades, when collapses occurred. Because they were so rare, when banking collapses did finally occur they would be totally catastophic (no-one would be prepared for them). And in the meantime because banks were not going bust, competition in the sector would be seriously damaged. Competition can only function properly when new entrants can drive out existing player, so that there is turnover in ideas and methods.  Companies going bust is not capitalism failing – it is capitalism working. We do not want banks less able to go bust – we want them more able to do so without bank failures leading to disaster for the wider economy!

Capital requirements take the form of the banks having to hold a certain percentage of their risk-weighted assets as capital (e.g. shares). So banks can deliver higher capital requirements in three key ways. They can raise extra money (e.g. issuing extra shares). They can reduce the size of their balance sheets, by making fewer loans or by calling in past loans.  Or they can reduce the riskiness of their loans (e.g. by refusing to make loans to as risky business ventures, focusing on lending only to nearly “sure things”).

The FSA has studied how banks actually respond to increased capital requirements in practice. What it found was two key things. First, it found that banks deliver about half of increased capital requirements by reducing their risk-adjusted balance sheets (i.e. by lending less and less risky) and about half by raising extra money. Second, it found that the order in which this happens is that first banks cut the size of their balance sheets, and only once that is largely achieved do they start raising capital. (This latter result in unsurprising – investors aren’t going to pour extra money into a bank with inadequate capital until it has proven that it can de-risk.)

The implication is twofold. First, regulators cannot expect to achieve both higher capital requirements and more lending at the same time. If you want banks to hold more capital, you must accept that they will lend less. If you want them to lend more, you can’t require them to hold more capital. The second is that responding to a financial crisis by increasing capital requirements should be expected to result in banks initially cutting back on lending even more than they might other do so. That is likely to damage wider economic growth, making households and businesses less able to repay their debts, so banks become more bust, so the financial crisis gets worse.  Increasing capital requirements in response to a financial crisis is a perverse policy response.

Capital provides a buffer. It does not exist to prevent banks ever going bust and is not a substitute for having proper mechanisms to allow banks to go bust safely. What is needed – what is desperately and urgently needed – to help resolve the ongoing banking crisis is not higher capital requirements. It is proper resolution mechanisms for failed financial institutions – in particular mechanisms that impose losses on bank bondholders (e.g. via debt-equity swaps). Losses for lenders, not taxpayers – shouldn’t be rocket science, should it? So why hasn’t it happened yet?