Capital Requirements Are Not Enough

The number of important people expressing serious concern about financial institutions that are too big or too complex to fail continues to increase. Since last fall, many leading central bankers including Mervyn King, Paul Volcker, Richard Fisher, and Thomas Hoenig have come out in favor of either breaking up large banks or constraining their activities in ways that reduce taxpayers’ exposure to potential failures. Senators Bernie Sanders and Ted Kaufman have also called for cutting large banks down to a size where they no longer pose a systemic threat to the financial system and the economy.

To its credit, the Obama administration recognizes the problem; according to Treasury Department officials, addressing “too big to fail” is one of the central pillars of financial reform, along with derivatives and consumer protection. However, the administration is placing its faith in technical regulatory fixes. And, as Andrew Ross Sorkin emphasizes in his recent Dealbook column, they see increased capital requirements as the principal weapon in their arsenal: “[Treasury Secretary Tim] Geithner insists that if there is one change that needs to be made to the banking system to protect it against another high-stakes bank run like the one that claimed the life of Lehman Brothers, increasing capital requirements is it.”

(Brief primer: Capital is money contributed by a bank’s owners–conceptually, their initial capital contributions plus reinvested profits–that does not have to be paid back. Therefore, it acts as a buffer to protect a financial institution from defaulting on its obligations as the value of its assets falls. The more capital, the less likely a bank is to fail. The more capital, however, the lower the institution’s leverage, and hence the lower its profits per dollar of capital invested–which is why banks always want lower capital requirements.)

Don’t get us wrong: we think that increased capital requirements are an important and valuable step toward ensuring a safer financial system. We just don’t think they are enough. Nor are they the central issue.

One problem is the question of where to set the capital requirements. The administration has proposed increasing capital requirements for the largest firms; because they are too big to fail, it is especially important that they be safe. But this requires knowing how much capital would be needed to withstand what used to be regarded as a relatively financial storm–a “tail event”–which is something that no economist should feel comfortable estimating today, given that such storms may have become more frequent. We believe it would be simpler to have a standard capital requirement for all banks, and make sure that none of those banks are too big to fail.

Another problem is how they will be set and enforced. The Treasury Department says that bank regulators already have the power to increase capital requirements, but they will do so as part of an international agreement that they hope to reach by the end of this year. (Current capital requirements are generally based on an existing international accord.) But because capital requirements are enforced by regulatory agencies, which have the power to overlook shortfalls on a case-by-case basis (called “regulatory forbearance”), they can be an unreliable instrument during an economic boom, when regulators are infected by enthusiasm wafting in from the financial markets, if not by the more sinister problem of regulatory capture.

Third, there is the problem that capital requirements, like all complex calculations, can be gamed. Lehman Brothers, for example, was more than adequately capitalized on paper–Tier 1 capital of 11.6 percent–shortly before it went bankrupt in September 2008. Thanks to the literally voluminous report by the Lehman bankruptcy examiner, we now know this was in part due to aggressive and misleading accounting. More generally, rampant use of regulatory arbitrage–techniques to artificially increase bank capital ratios–was a factor in the failure of AIG (much of whose business was enabling European banks essentially to evade capital requirements) and the near-failure of Citigroup (which was almost capsized by the structured investment vehicles it created to evade capital requirements).  

Capital requirements alone are not a reliable tool for preventing the collapse of systemically important financial institutions. Like other regulatory refinements, they depend on the ability and motivation of regulators to rein in financial institutions that have clear incentives to evade them at every opportunity. They also fundamentally reflect the belief that we are smart enough to prevent large financial institutions from collapsing in future financial crises.  And the critical underlying assumption is that we will never again have a president in the United States who seeks to deregulate everything in sight; such an assumption would be unrealistic and dangerous.

We think the better solution is the “dumber” one: avoid having banks that are too big (or too complex) to fail in the first place.  In our book, 13 Bankers, we propose strict asset caps (as a percent of GDP, i.e., relative to the size our overall economy) on financial institutions that are adjusted for the types of assets and obligations held by those institutions – if they want to take more risk, they need to be smaller. We cannot predict what kind of trouble the next generation of bankers will be able to concoct for themselves. But we can try to make sure that when it does happen, we can let them fail without having to bail them out with taxpayer money.


Originally published at The Baseline Scenario and reproduced here with the author’s permission.  

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