It’s understandable that bank regulators, facing zealous industry opposition, are retreating from their effort to require the biggest lenders to fund their assets with more equity. After all, there hasn’t been a major blowup in 18 months and the banks insist they have more than enough capital.
The problem is that it isn’t true. Without stronger rules in place, the odds of another financial crisis — and massive bank bailouts — will continue to grow.
After the 2008 crisis led to the worst recession since the Great Depression, regulators around the world agreed on a plan — called Basel III — to ensure that bank shareholders (and not governments) would provide the capital needed to absorb losses. To calculate how much capital was needed, the plan modeled the risk of different assets — an inexact science that the banks could game.
The US enacted a backstop to those risk-weightings that required the eight biggest banks to have enough equity to fund at least 5% of their total assets, including off-balance sheet exposures. Even that seemed low: At least one projection in early 2009 estimated that US banks’ assets would lose a total of 10% of their value, while academics say banks should fund at least 15% of their assets with equity to avoid bailouts. But as new regulations took effect, and banks started losing business to less-regulated lenders and other financial service companies, political support for any tougher requirements dissipated.
Last year’s failure of Silicon Valley Bank and three other seemingly well-capitalized lenders provoked a fresh sense of urgency — and an opportunity. Regulators should’ve proposed a simple increase to the minimum ratio of equity to assets required, ideally getting it closer to 15% on some phased-in timeline.
If that sounds impossible, consider that most US banks had much higher amounts in the past. Plus, the biggest banks had already started conserving some capital in 2022 and 2023 in anticipation of the final phase of the Basel III process.
Instead, the Federal Reserve and other US regulators put out an overly complex “endgame” proposal that tinkered with the risk measurements on banks’ balance sheets and called for only a modest increase in capital. Most banks already had enough to meet the proposed requirements, and the others would have been able to get there in about two years through retained earnings without cutting dividend payments.
Still, the 1,087-page proposal failed to get unanimous support from board members at the Fed or the Federal Deposit Insurance Corp. The eight big banks, furious at being singled out after the failure of their smaller competitors, unleashed an unprecedented public-relations campaign and threatened to sue.
The onslaught worked. On Sept. 10, Fed Vice Chair for Supervision Michael Barr backed a new proposal that would address some valid criticisms of the convoluted risk measurements — but also scale back the demand for more capital. As a result, several banks have already started to redeem preferred shares, reducing their use of equity from levels meant to anticipate the new rules. Having tasted victory, the banks are preparing to challenge the new proposal as well.
A humbled Barr said the retreat was needed “to get the balance between resiliency and efficiency right” and to ensure a “well-functioning economy.” Excellent goals — but a “well-functioning” economy requires strong banks, which means banks that can keep lending and serving their customers even if they suffer serious losses. The regulators appear to be settling for the prospect of renewed banking fragility, leaving taxpayers on the hook for the next round of bailouts.
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