The Fight Over Bank Capital Keeps Missing the Point

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?