In recent months, capital has emerged as a singular focus for many policymakers and banking industry observers hoping to enhance the safety and soundness of the nation’s banks and avoid a repeat of the 2008 crisis. Since capital protects banks from losses, the thinking goes, more and more capital will make banks safer and safer, and bank failures – and potential bail-outs – less likely. And because capital isn’t free, some contend, higher required capital will also discourage big banks from growing bigger, and might even incentivize already large banks to downsize.
Testifying before the Senate Banking Committee on June 6th, Federal Reserve Board Governor Dan Tarullo stated: “[T]he best way to safeguard against taxpayer funded bailouts in the future is for our large financial institutions to have capital buffers commensurate with their own risk profiles.”
Ranking member Richard Shelby (R-AL) responded to Mr. Tarullo’s assertion by stating: “I think it’s a given that there is no substitute for capital.”
On August 6th, Senators Sherrod Brown (D-OH) and David Vitter (R-LA) sent a letter to Federal Reserve Chairman Ben Bernanke stating that recently announced changes that quadruple minimum capital requirements for the largest banks are “far too low.” More capital, the Senators write, “is a common sense way to fix the dangers of too-big-to-fail,” and, therefore, required capital should be set at levels that will “either incent [the largest banks] to become smaller or will help to ensure they can weather the next crisis without another taxpayer bailout.”
Capital, it seems, is king.
To be sure, a heightened focus on capital is entirely appropriate. A bank’s capital is the simple difference between the value of its assets and the value of its liabilities – the bank’s net worth. Typically comprised of investor equity, retained earnings, and various types of debt obligations, capital serves the important economic purpose of providing a buffer or cushion against which unexpected losses can be absorbed without jeopardizing the bank’s viability. Sufficient loss-absorbing capital is a critical – not just important, but critical – aspect of any bank’s health and stability. All else being equal, a bank holding more capital is healthier and more stable than a bank holding less. And it is certainly true that many banks held too little capital before the recent financial crisis.
But it is also true that capital is not a silver bullet solution to the challenge of ensuring financial stability. In fact, unnecessarily high levels of capital can become problematic and even counterproductive.
Since the financial crisis, the capital position of U.S. banks has dramatically improved. In March, the Federal Reserve announced the results of the latest Comprehensive Capital Analysis and Review (CCAR), better known as the stress-test, which showed that since 2009 the 19 largest bank holding companies have nearly doubled levels of Tier 1 common equity capital – the highest loss-absorbing form of capital – from $420 billion to $760 billion as of the fourth quarter of 2011. The additional capital has raised the average ratio of Tier 1 common to banks’ assets weighted to reflect risk from 5.4 percent to 10.4 percent. Moreover, under the terms of an agreement issued by the Basel, Switzerland-based Committee on Banking Supervision, the eight largest U.S. banking companies will be required to hold even higher capital – a surcharge of between 1 and 2.5 percent of risk-weighted assets – by 2019. Overall, banking industry regulatory capital is currently at or near record levels.
In releasing the stress test results in March, the Fed said that 15 of the 19 banks examined would be able to maintain sufficient capital under a crisis scenario that entailed a combination of an unemployment rate soaring to 13 percent, a 50 percent drop in stock prices, a 21 percent further decline in housing prices, and steep falls in prices of financial assets most exposed to conditions in Europe.
Commenting on the results in a May 10th speech, Chairman Bernanke stated: “Under this highly adverse scenario, the 19 bank holding companies were projected to incur aggregate losses of more than $500 billion through the fourth quarter of 2013. Nevertheless, their aggregate Tier 1 common ratio was projected to be 6.3 percent at the end of the scenario period, and 15 of the 19 bank holding companies were projected to maintain capital ratios above all four of the regulatory minimum levels – even after taking into account their proposals for capital actions such as dividends, share buybacks, and share issuance in the baseline scenario.”
Karen Shaw Petrou, managing partner at Federal Financial Analytics, told Bloomberg News: “Any bank that remains adequately capitalized under these acute stress scenarios is not just strong, but darn-near impregnable.”
It’s important to emphasize that the dramatic improvement in bank capitalization has been achieved even as banks have made other improvements that have significantly reduced their overall risk. For example, liquidity has dramatically improved, with large banks more than doubling their holdings of cash and liquid securities since 2009. Leverage has been reduced, in some cases cut in half. Asset quality is far stronger, with noncurrent loan balances declining for nine consecutive quarters and charge-offs falling for eight consecutive quarters to their lowest levels since early 2008. Risk management, internal controls, and governance procedures have been significantly enhanced. And compensation structures at most banks have been reformed to closely align the personal incentives of bank employees with the long-term performance and safety and soundness of the employing institution. Together with near record levels of capital, such improvements make for a far healthier and more stable banking system.
And yet, Senators Brown and Vitter insist that current capital levels are “far too low.” Observing that in the 1920s large banks maintained capital ratios of 15 to 20 percent, the Senators imply that such levels might be appropriate today. This notion overlooks important changes since 1920 – such as the creation of deposit insurance, not to mention 90 years of technological advancement and its impact on banks’ risk management capabilities. More importantly, such calls for higher capital overlook the fact that additional capital is not without costs or consequences, and can become counterproductive and even dangerous.
For example, too much capital can obstruct banks’ ability to perform their critical role in the economy by limiting lending capacity. Economic growth and job creation suffer if credit is scarce. While it’s true that no bank ever failed from holding too much capital, an overcapitalized bank is just a pile of idle money – like a plane that never attains altitude. An underperforming economy due to insufficient credit availability ultimately undermines banks’ safety and soundness by impairing asset quality and earnings.
An overreliance on capital as a kind of supervisory silver bullet can also lull policymakers and regulators into a false sense of security, distracting them from other equally relevant aspects of safety and soundness. Capital is a central aspect of banks’ well-being, but only one of many. Other critical factors include the nature and strength of a bank’s assets, the rigor and effectiveness of its risk management framework, the soundness of its internal controls and governance procedures, the quality and diversity of its earnings, and the reliability of its liquidity position. All these factors, considered together, and in relation to one another, determine overall safety and soundness. Indeed, considered in isolation, outside the context of other essential aspects of safety and soundness, a particular capital level has limited meaning or supervisory value.
A quick, if somewhat silly, example:
If I told you that John weighs 175 pounds, could you say whether John’s weight is healthy? That weight sounds reasonable, and would be if the John being discussed is me – 48 years old and six feet tall. But 175 pounds would not be appropriate if the John in the example is my father, who is 6 feet, five inches tall. And it would be extremely unhealthy if the John in question were my 6 year-old son. Without knowing other relevant aspects of John’s physical circumstances, the fact that he weighs 175 pounds tells you very little about his overall health.
Worst of all, excessive capital can become perverse – potentially incentivizing greater risk-taking by banks. How? Higher and higher levels of capital erode banks’ return on equity (ROE), a key measure of profitability. A recent report estimates that had the Basel-mandated capital surcharges been imposed on the largest U.S. banks as of the fourth quarter of 2011, their average ROE would have been reduced by 10.3 percent. As ROE declines, banks’ ability to attract the additional capital that regulators are requiring becomes more and more difficult. At some point, therefore, generating the returns necessary to attract additional capital from investors may require taking greater risk.
Capital is important. Capital is critical. But as is the case in many other contexts, too much of a good thing can be bad. The capitalization of U.S. banks has dramatically improved since the financial crisis. Overall capital is at or near record levels, and improvements in many other relevant areas have significantly reduced banks’ overall risk profiles.
Rather than indulging in overkill to the detriment of economic growth and job creation, let’s capitalize on the progress achieved to date by allowing banks to do what they’re intended to do – propel economic growth and job creation by supplying the credit that American businesses, homeowners, and consumers need.
By John R. Dearie
Executive Vice President for Policy
Financial Services Forum
 FDIC, Quarterly Banking Profile, First Quarter 2012
 FDIC, Quarterly Banking Report, Second Quarter 2012
 “Why More Capital Means Lower Return on Equity for Largest U.S. Banks,” Bloomberg Government, Christopher Payne, March 7, 2012.
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