Some Capital Ideas

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How could regulators have averted something so complicated in origin as the financial crisis? By many accounts, the most sensible approach would have been something quite simple: require more bank capital.

Financial market regulators have a fundamental problem: Only in bad times is there broad political support for reform and toughened standards, and by then the damage may have already been done.

Consider a lesson from recent history: When the internet bubble burst, the fallout was mainly limited to the stock market. But the housing bubble’s explosion sent shock waves through the entire economy. One explanation for these divergent courses is that internet firms were largely funded with equity (a.k.a. capital) while the housing market was fueled almost exclusively by debt.

In November, the Federal Reserve Bank of Cleveland invited three scholars of finance and economics to talk about the virtues and pitfalls of bank capital regulation. Their insights helped shed light on how raising capital requirements might make a large difference in the durability of financial institutions—and why even in the day of Dodd-Frank and Basel III, adopting heightened standards remains necessary, even if difficult to achieve.

Capital is Not a Four-Letter Word

Anat Admati, the George G.C. Parker
Professor of Finance and Economics
at Stanford University

Few things get Anat Admati more worked up than the financial press’ mangling of the word “capital.” Admati, the George G.C. Parker Professor of Finance and Economics at Stanford University, has collected some of her favorite euphemisms for capital, all of which she considers highly misleading: “hold,” “set aside,” “cash.”

But as Admati points out, a firm does not “hold” financial securities it issues; investors do. The phrasing favored by journalists and bankers misleadingly suggests idle funds, passivity, and costs. “Capital requirements are an equity requirement. They are about how much to borrow or not to fund your balance sheet. They don’t tell you how to spend your money—just how to fund it,” Admati said.

What’s useful about equity is its ability to absorb losses without triggering legal difficulty. If a financial institution with $20 of equity takes a $15 loss, then shareholders take that hit, but ostensibly the firm remains solvent and there are no systemic spillovers of the loss. But if the same firm was funded with just $5 of equity and $15 of debt, that $15 loss is lethal and potentially systemically disruptive assuming we’re dealing with a systemically important financial institution.

Bankers generally oppose strengthened capital requirements. They argue that capital is expensive, would hurt one of their key performance measures—return on equity (ROE)—and ultimately would force them to charge higher rates on loans to offset their increased costs.

Admati doesn’t buy that. Does equity have a higher required return than debt? Yes, she said, but that doesn’t make it “expensive” in any relevant way, because asyou use more equity, its required return declines because it becomes less risky. Nor is ROE the appropriate measure, unless it is adjusted for risk. Investors, after all, care about risk-adjusted returns, not raw ROE. There are essentially no relevant costs, only benefits, to the economy from banks relying on significantly more equity and less debt. If they retain more earnings, they can build up equity without disrupting any lending. The benefits to the economy are also potentially vast, given the decreased fragility that well-funded financial institutions will bring.

Managing the Transition to Higher Capital Standards

Robert McDonald, Erwin P. Nemmers
Professor of Finance at Northwestern University

It is one thing to discuss the theoretical implications of requiring higher capital. It is quite another to make it happen. Financial institutions are different creatures than their nonfinancial counterparts.

Robert McDonald, the Erwin P. Nemmers Professor of Finance at Northwestern University, notes several of these differences: Financial firms have a lot more debt in general, they use a lot more short-term debt, and their assets tend to be more mobile and fungible (that is, they can often be converted into different types of assets).

Financial firms are able to take on so much debt in large part because of the implicit and explicit taxpayer support they enjoy. The government safety net includes deposit insurance as well as implied “too-big-to-fail” protection for the largest institutions. The rates at which financial firms are able to borrow reflect this subsidy. The upshot is that markets are not fully charging for the costs of financial firms’ risky activities.

Bankers respond that if you raise capital requirements, banks will need to charge higher rates on loans. McDonald is not impressed with this argument. “It’s privately expensive only in the sense that if the too-big-to-fail banks were to replace a lot of debt with equity, then they would basically be reducing the value of their subsidy,” he said.

McDonald’s point is that if banks can borrow at artificially low levels because of the safety net, then requiring more capital will raise bank funding costs. You might not want to do this when the unemployment rate is very high. But apart from that, if borrowing rates increase because the subsidy goes down, that’s efficient and should lead to better lending decisions.

One approach that seeks to balance those concerns is to use an instrument called “contingent capital.” McDonald has studied the possibilities of contingent capital, which is a financial claim that converts to equity at some trigger point, such as when a bank’s stock price hits a certain low or a systemic risk index reaches a certain threshold. McDonald has concluded that contingent capital has a host of problems. Among themis determining where that trigger point should be, because in some cases it could be manipulated and or end up at any number of share prices that might only worsen the systemic crisis.

The Regulators’ Task

Richard (Rick) Carnell,
Professor of Law at Fordham Law School

Financial market regulators have a fundamental problem: Only in bad times is there broad political support for reform and toughened standards, and by then the damage may have already been done. Richard Carnell, professor of law at Fordham Law School, and a former assistant secretary of the Treasury, argues that had bank regulators fully availed themselves of all the tools in their existing toolkit, the financial crisis may well have been averted. They didn’t, however, in part because they lacked the political backing in the run-up to the crisis, when the economy seemed to be humming along and no one could imagine housing prices ever falling, Carnell said.

Assuming some measure of political support, a starting point for capital reform would be to determine how much capital the private market would require if there were no deposit insurance and no expectation of a government rescue. There is nothing sacred about existing capital ratio rules. “The accustomed capital ratios we have today are just matters of habit. They were the best regulators could do at the time,” Carnell said.

Well-capitalized banks will have positive ripple effects across the financial system, Carnell said. They will inspire greater confidence and make less likely “Minsky moments” (when debtors are forced to hold fire-sales of their assets and financial markets suffer widespread sharp declines) and perhaps make them less severe. “Higher equity levels in banks make banks more resilient,” Carnell said.

Although the academics disagreed on the margin on a number of points, they did all agree on one important point: Bank capital requirements need to go up.

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Meet the Author

Douglas W. Campbell

| Executive Speechwriter

Douglas W. Campbell

Doug Campbell is the executive speechwriter in the Public Affairs Department at the Federal Reserve Bank of Cleveland. He also leads the public-official outreach function and is founding editor of Forefront, the Cleveland Fed’s policy publication. He previously served as a policy advisor, economics writer, and editor.

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