Why regulators should be tough on bank capital

By Felix Salmon
September 7, 2010
John Carney today writes about what he calls "the deeper problem" behind the Basel III negotiations: "how regulators can assess capital requirements without a functioning market process".

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John Carney today writes about what he calls “the deeper problem” behind the Basel III negotiations: “how regulators can assess capital requirements without a functioning market process”.

Ideally, he says, “we wouldn’t have regulatory capital requirements at all”, and banks would voluntarily raise their capital levels because doing so would decrease their funding costs. But in an age of moral hazard and government guarantees, that doesn’t work.

But underlying all of this is the idea that there’s an art to setting an optimal capitalization ratio, so that it’s not too high and not too low. My feeling, by contrast, is that left to their own devices banks will always have too little equity and too much debt, for the reasons that Carney glosses and also just because they tend to trust each other too much, believing that in extremis they can always exit most of any given interbank position overnight.

Certainly I haven’t seen any correlation between leverage and profitability when it comes to the world’s banks. The most profitable bank I’ve ever covered on a regular basis is Brazil’s Banco Itaú, and it tends to have pretty conservative leverage. Meanwhile, Europe is full of extremely highly-levered banks which make relatively modest profits.

It seems to me, then, that excess banking-system leverage is something which happens in mature markets when the normal engines of bank profitability, such as loan growth, start running dry. In Carney’s ideal unregulated market, banks would start off with quite high capital ratios when economies are young and growing fast, and then slash that equity in a desperate attempt to preserve return on equity as their economies start to mature and growth slows down.

And while the emerging markets are no strangers to banking crises, the fact is that the most dangerous such crises are always the ones which take place in large, mature economies.

That’s where regulators — by which I mean the Bank for International Settlements, in Basel — have to step in, by forcing all countries to adopt a bare minimum capital requirement which will protect the system in two main ways: it will make bank failures less likely and less frequent, and it will improve the ability of the rest of the system to withstand any bank failure which does still occur.

Within reason, and so long as the requirement is imposed globally, there’s no reason that it can’t be very strict indeed; the noises coming out of Basel are a very good start. There’s very little downside to tougher capital requirements, and the people who complain about them most likely are probably just those who fear that their bonuses are going to fall. But that’s a feature, not a bug.

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