Introduction
Since the release of the banking agencies’ Basel III Endgame capital proposal in late July, it has been suggested that the proposed 20 percent capital increase for U.S. GSIBs is nothing to worry about because “the banks already have enough capital” to satisfy the elevated requirements or, better yet, the banks can retain enough earnings over several quarters to “meet the requirements.” For example, even though minimum requirements are set to increase by roughly 20 percent, say from 100 to 120, some banks already maintain a level of capital in excess of the proposed new requirements, say 125, or maintain enough capital, say 115, such that they would have enough capital by halting payouts and retaining earnings for several quarters and building their capital base to the proposed required level of 120. It is unfortunate that such an important public policy issue has to be clouded by such diversionary rhetoric that is both wrong and wholly irrelevant to the matter at hand. Analogizing to a more familiar economic context, imagine being told that an oncoming tax increase was nothing to worry about because “you already have more than enough money to pay the tax.” Such a non-sequitur does not survive even the most basic economic analysis. In the remainder of this post, we discuss the clear and obvious fallacy behind the claim that proposed increases to required capital are nothing to worry about.
Clearing Up Three Misconceptions
The notion that increasing required bank capital is not a problem because the banks already have enough is a dangerous misconception that belies the most basic understanding of banking and capital. Below we explain this fallacy by describing three basic realities of large bank capital.
1. Banks not only maintain the absolute minimum level of required capital, they also maintain a buffer over and above minimum requirements because the world is uncertain and they are prudent.
Imagine you are driving your car to work, which is 20 miles away and your gas tank has just enough fuel to make it. Most reasonable people would still stop by the gas station and put a few dollars in the tank because you never know what might happen on the way to work. Perhaps you will hit a traffic snarl. Perhaps a road will be closed, and the detour will take you a few miles out of your way. The idea that you should not drive your car with the absolute minimum amount of gas required is common sense. Banks regularly maintain capital over and above the required minimum for exactly the same reason. The future is uncertain and falling below your minimum requirement is very costly because regulators, investors, and depositors all have a very swift and strong reaction to a bank that breaches its minimum capital requirement. Basic risk management demands a better approach to managing capital levels.
As a result, banks maintain a cushion, or a “management buffer,” over and above the minimum requirement to guard against unforeseen events that would reduce their capital level. If capital requirements rise, banks respond by increasing their capital to a level that provides sufficient “capital headroom” over and above the new, higher requirement. Going back to the driving example, suppose a driver has a 10-mile safety buffer of gas so that he can drive, say, 30 instead of 20 miles. If the driver gets a call from his boss and is told he needs to drive not to the office but to a client’s office, which is 28 miles away, the driver will put more gas in the tank to ensure he can make it to the client’s office and not get stranded en route even though he has enough gas to travel 30 miles.
Claims that banks already have enough capital entirely miss the basic point that banks operate with a management buffer above minimum requirements. Moreover, the precise amount of “extra gas in the tank” that banks maintain depends on the nature of the requirements themselves, the scope for future risks, and a variety of other technical factors. Attempts to judge “how much is enough” by pundits is just garden-variety armchair quarterbacking that adds little to the debate.
2. Banks begin responding to anticipated capital increases long before they come into effect. Accordingly, current capital levels represent, at least in part, anticipated future increased capital requirements.
A very basic tenet of modern economics is that people base their actions, not on current conditions, but anticipated future conditions. To quote the Great One, hockey legend Wayne Gretzky, “skate to where the puck is going to be, not where it has been.” Banks, like good hockey players, anticipate. In the case of banking, anticipation is critical because many business decisions, such as making a 5-year business loan, tie up a bank’s balance sheet for years. As a result, the bank must account for both current and future levels of required capital. This accelerates the impact and costs of higher requirements on all bank customers and the economy.
Banks’ proclivity to adjust capital levels before a rule comes into effect is well understood and clearly documented. A research study by the Federal Reserve examining the timing of capital impacts related to the prior Basel III capital reform found that “the bank responses we estimate take place well before the Basel III rules started to come into force after 2014, emphasizing the importance of policy announcements in shaping bank behavior.”
Claims that banks already have enough capital entirely misses the basic point that current capital requirements already reflect, to at least some extent, anticipated future requirements.
3. Capital is the most expensive form of finance. As a result, banks are careful stewards of that precious resource and any bank that maintains unnecessary “surplus” capital on its balance sheet would find itself outcompeted by other banks and shunned by investors.
The idea that bank capital is somehow in abundant supply and so greater requirements are of no concern would make some sense if banks regularly maintained purely surplus amounts of capital that had no specific design or purpose. Market competition and prudent financial management, however, ensures that this never happens for the same reason that car companies don’t maintain large, surplus inventories of steel that aren’t needed to meet their production goals. A company that regularly maintained excessive and unnecessary inventories would tie up precious funds that would increase the cost of production. Competing companies would easily undercut the company and investors would soon pull their capital from such a poorly managed company to invest in better run companies. Banks are no different. Banks are careful stewards of their capital resources. As a result, whenever you observe the amount of capital maintained by a bank you are observing the amount that is required to run the bank safely and profitably at that time. Increasing capital requirements would simply place additional upward pressure on the amount of capital required to run the bank and add to the cost of banking and financial services.
Claims that banks already have enough capital assume that banks regularly maintain surplus amounts of capital on their balance sheet that have no specific purpose and can be used to fulfill new requirements at no cost. This view of banking is wholly inconsistent with fundamental notions of competition and financial management that are a basic reality of the banking sector.
Conclusion
Capital is not a free resource. Suggestions that oncoming heightened capital requirements are nothing to worry about because “banks already have enough capital” is incorrect and fails to recognize basic economic truths about banks and capital. Rather than engage in diversionary rhetoric, we should all focus on the key question at hand – what is the case for higher bank capital requirements in the first place? Regulators have yet to provide any substantive rationale for higher capital requirements for U.S. GSIBs. And rather than engage on this substantive question, it seems that there is now a desire to simply assert that “the banks can afford it.” Making a significant regulatory change without a clearly articulated rationale and simply stating that “it’s not a problem” is poor public policy. The focus should be on the basis for these proposed capital reforms before we all end up paying a cost that may simply be unnecessary.