US financial regulators have been working on what’s optimistically known as Basel III Endgame – the long, slow effort to reform global banking rules following the crash of 2008. They’re apparently getting cold feet. After strong pushback from the banking industry, Federal Reserve Chairman Jerome Powell recently said the proposal regulators announced last summer is going back to the drawing board. That’s where it belongs, but not because it’s too demanding. Quite the opposite.
The proposal calls for higher capital requirements for big banks and banks that trade a lot of securities. The increases are too small. More important, they ignore a better approach to banking risk. More than 15 years after the crash, the effort to make banking as safe as it should be is stumbling yet again.
In 2013, Stanford’s Anat Admati and Martin Hellwig of the Max Planck Institute for Research on Collective Goods made the case for much higher capital requirements. A new edition of The Bankers’ New Clothes has just been published. It has valuable new chapters, but the essential point is the same: Banks take risks, so they need to fund themselves in ways that can absorb losses. One form of funding, bank deposits, can’t absorb losses because depositors expect to be paid back in full on demand. But banks make no such promise to their shareholders. Therefore, to be safe – and to protect taxpayers from the recurring need to bail out failures – banks should use more equity.
How much, exactly? The book says 20%-30% of banks’ loans and other investments.
Just before the crash, the country’s biggest banks used equity to finance only 5% of their investments. By last year, this had increased to 7%, still vastly lower than what Admati and Hellwig recommend. Note that Basel III envisages an equity ratio of just 5% – less than what the big banks currently use and no more than they used before the crash. Which prompts two questions. First, what are regulators thinking? Second, if the big banks are already more than complying with the rule, why are they pushing back?
Banks and their regulators don’t much care about this simple ratio of equity to assets – the Tier 1 leverage ratio, as it’s called. As the numbers show, it doesn’t bind the biggest banks, and there are no plans to make it bind. The new rules focus instead on so-called risk-weighted assets, which ties equity requirements to the estimated risk of different kinds of investments, from supposedly safe government bonds to the riskiest kinds of unsecured loans. Under the new rules, this approach would indeed tell big banks to increase their use of equity – though by very little, measured against the standard that Admati and Hellwig advocate.
Last year’s failure of Silicon Valley Bank was instructive on the need to adjust the level of capital for risk – or should have been, anyway. According to the rules, SVB’s investments in government fixed-interest securities were safe. When interest rates rose and bond prices fell, the value of the bank’s investments tanked – but losses on assets that the bank expected to hold to maturity were deemed not to count, on the grounds that they would never be realized. In 2022, the year before depositors ran and brought it down, SVB was already insolvent because its unrealized losses exceeded the bank’s equity. Yet in risk-adjusted terms, all was well. Had the bank been required to maintain a simple equity ratio of 20%, it would have stayed solvent, depositors might not have run and shareholders could have borne the losses.
So you can forgive the tone of exasperation that runs through both editions of The Bankers’ New Clothes. All these years after the crash, despite legislation, regulatory back and forth, ceaseless lobbying, contention and new bank failures, Admati and Hellwig still appear to be talking into a void. Regulators and their subjects argue about the pros and cons of marginal adjustments while ignoring the big picture.
That said, the authors sometimes do their case a disservice by dealing with awkward questions a bit disingenuously. One of the counterarguments they dismiss, for instance, is that equity finance is more expensive than debt, implying that tougher equity requirements would make borrowing more expensive, banking less profitable, and/or banking services less available. Another is that higher equity requirements would drive intermediation away from banks toward less-regulated “shadow banks,” shifting risk and possibly increasing it. These claims are indeed flawed, as Admati and Hellwig say – but neither, as they quietly admit, is straightforwardly false.
Equity is more expensive than debt, they say, partly because it doesn’t benefit from the implicit subsidies that tax preferences confer on debt. If you were to eliminate those subsidies, as Admati and Hellwig would prefer, debt would have a smaller cost advantage (although the difference might not fall to zero). Similarly, stronger equity requirements for banks would push business into the shadow-banking sector. But this objection is misleading too, they say. The shifting of risk is a reason to regulate shadow banks more effectively, not to be less stringent regarding banks.
They’re correct on both points, but these answers suggest their prescription is more complex than it looks. It also side-steps underlying trade-offs. After all, there must be such trade-offs: Otherwise, why not insist that banks finance their lending not with 20% or 30% equity but with 50%, or 100%? Or why not turn banks into “narrow banks” by requiring deposit-taking institutions to back such liabilities one-for-one with cash and balances at the central bank? Admati and Hellwig say they don’t want to abolish banks. Well, why not? The answer is that, although banking necessarily involves risk, it serves valuable purposes. That’s another way of saying you can have too much safety as well as too little.
Because of these complications, it isn’t obvious what an adequately reformed financial system, according to The Bankers’ New Clothes, would look like. Sure, much more use of equity to make banks safer. Also required: tax reform to eliminate subsidies for debt. Also required: more stringent regulation of non-bank financial intermediation. In addition: careful attention to who knows how many other unintended consequences of moving abruptly down this path. In the end, no doubt, the fundamental financial-policy trilemma as stated by Jon Danielsson and Charles Goodhart of the London School of Economics would also assert itself: We want strong economic growth, low inflation and financial stability – but we can’t have all three.
Be that as it may, we can do better. The right balance for bank equity is certainly closer to what Admati and Hellwig propose than what Basel III Endgame envisages, let alone where things currently stand. The increase in equity that followed the crash defied predictions and had no apparent adverse consequences. There’s no good argument against moving further in that direction.
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