Capital Requirements: Cleveland Fed Conference Offers Lessons Learned for Policymakers
Will requiring financial institutions to hold more capital prevent another financial crisis? Perhaps, but modifying capital requirements means addressing a number of unresolved issues ranging from the costs of increased requirements to the best way to structure them. Economists Joe Haubrich and James Thomson from the Federal Reserve Bank of Cleveland say that research presented at a recent Bank conference offers some lessons learned for policymakers, such as:
--High capital requirements have large social benefits – reducing the extent and severity of financial crises – and low social costs.
--Research suggests that a capital ratio around 20 percent is optimal.
--There are major social benefits from replacing 10 percent of debt with contingent capital, above and beyond banks’ capital holdings. This implies increasing capital from about 6-10 percent to 15-20 percent.
--There are two camps on liquidity requirements – some researchers find them more effective than capital requirements in promoting bank safety, while others view them as costly because they induce banks to voluntarily hold levels of capital above 30 percent.
A final theme emerging from the conference is that the form of regulation matters, whether it is the triggers on contingent convertible capital (or CoCos), the interaction between capital and liquidity requirements, or the specific method used on stress tests.
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