Wall Street Should Stop Complaining About New Bank Capital Rules

 

Wall Street is kvetching up a storm over modest toughening of megabank capital requirements by federal regulators. “This rule puts American financial institutions at a clear disadvantage against overseas competitors,” Tim Pawlenty, chief executive of The Financial Services Roundtable and former GOP presidential candidate, told Reuters.

The new rule increases the required leverage ratio – the amount of equity capital a bank holds as a share of assets — to 5% versus the 3% ratio in the international Basel III agreement. Under the new rule, megabanks could borrow only 95% of money they lend versus 97% under Basel. By 2018, they would have to rely more on selling stock or retained earnings.

If other nations want riskier big banks, that’s the business of their taxpayers, who’ll be on the hook for future bailouts. A tougher leverage ratio and bigger safety cushion make the US financial system somewhat safer, but not as safe as it could and should be. The US has suffered 14 major banking crises over the past two centuries, as documented by Charles Calomiris and Stephen Haber in their new book, Fragile by Design: The Political Origins of Banking Crises and Scarce Credit. (None in Canada, by the way.) One could reasonably assume US economic growth would have been a least a smidge better without all those other crises.

In a recent Wall Street Journal op-ed, Calomiris and coauthor Allan Meltzer note that, at the start of the Great Depression, the big New York City banks “all maintained more than 15% of their assets in equity” and none went bust. Likewise, “losses suffered by major banks in the recent crisis would not have wiped out their equity if it had been equal to 15% of their assets.”

Wouldn’t a 15% leverage ratio hurt bank lending and economic growth? Consider: First, you have to calculate whether it would hurt economic growth more than a continuation of America’s serial financial crises. Second, it’s a pernicious myth that debt is somehow “more expensive” than equity capital. The more stock a bank issues, the less risky the bank becomes, and the lower the return shareholders demand.

Don’t banks know this? Look, banks are responding to incentives. Bank debt operates on unequal footing thanks to Washington’s “too big to fail” backstop. University of Chicago economist John Cochrane explains that, without government guarantees, “a bank with 3% capital would have to offer very high interest rates—rates that would make equity look cheap.” Like researchers Anat Admati and Martin Hellwig in their book The Bankers’ New Clothes, Cochrane endorses dramatically higher capital levels. So should policymakers if they want to avoid another century of financial shocks.

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  1. Tuck Inactive
    Tuck
    @Tuck

    I think the banks’ behavior can be explained by the fact that they’re managed by managers, not owners.  Managers who are not owners have an incentive to take risk, as if they make a good bet they will be compensated for it, and if they don’t the shareholders will lose, and they’ll get fired, at worst.

    Given that the managers can reasonably expect to be bailed out, even the fear of firing is removed…

    But if they accept higher capital requirements, their ability to make risky bets will be impaired.

    I think their behavior is entirely rational, given the parameters with which they operate.

    • #1
  2. Eric Hines Inactive
    Eric Hines
    @EricHines

    If other nations want riskier big banks, that’s the business of their taxpayers, who’ll be on the hook for future bailouts.

    This applies to the US, too, and it’s a demonstration of Pethokoukis’ false premise.  Taxpayers never should be on the hook to bailout a business.  Full stop.

    Only the business’ owners and investors–which include depositors in the case of banks–should be on the hook.

    The US has suffered 14 major banking crises over the past two centuries….

    And the worst of them were made so by government interference.  A textbook case of a banking crisis that didn’t need government intervention to right itself is the Panic of 2007, which recovery was potentiated by…a private banker.

    Bank debt operates on unequal footing thanks to Washington’s “too big to fail” backstop. University of Chicago economist John Cochrane explains that, without government guarantees, “a bank with 3% capital would have to offer very high interest rates….

    There’s a hint there.  Lose the government bailout backstop.  You and I have better things to do with our money, allocated by us to the Federal government as tax payments, than to prop up failing enterprises just because they’re of a size.

    Eric Hines

    • #2
  3. James Of England Inactive
    James Of England
    @JamesOfEngland

    I think that there are decent arguments that various bankers are wrong about this, but I think it’s a shame to frame that argument in a claim that they should not speak. James honorably claims they should suffer more regulation, but they can disagree honorably. American greatness has not been built on the silence of the erroneous.

    • #3
  4. Fake John Galt Coolidge
    Fake John Galt
    @FakeJohnJaneGalt

    Stop bailing banks out and this goes away.  If a bank does go bust lock their executive level officers away for a few years To give them some skin in the game.

    • #4
  5. user_961 Member
    user_961
    @DuaneOyen

    Higher capital requirements are absolutely called for- the best analyses call for a level closer to 15%, not 5%, and most assuredly not 3%.  But the only way to eliminate too-big-to-fail is to eliminate “too big”.  Arnold Kling explains.

    And, BTW, we need to stop listening to the whining about competitive disadvantages vis-a-vis other foreign  banks.  ING was bailed out by the Dutch government, etc.  If these countries want to impoverish their citizens in order to enable a big banking presence, let them.  I have a feeling the US would be far better off if

    And James P, I strongly encourage you to do a podcast with Arnold Kling about the bank size limits.  He has a resume of credibility on this stuff and is a solid libertarian economist.

    • #5
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