Why Higher Capital Standards Are Needed

Today's Economist

 

Why Higher Capital Standards Are Needed

By SIMON JOHNSON

 

 

At one level, the pursuit of higher and more robust capital requirements for banks is not going well. The United States Treasury insisted, throughout the yearlong financial reform debate, that capital should be the focus — increasing the loss-absorbing buffers that banks must carry — and that it (and other regulators) needed to negotiate this is through the Basel Committee process.

But Basel has come under great pressure from the banking lobby, which argues that any increase in capital requirements would limit lending and slow global growth, an issue discussed by Douglas Elliott in this useful paper. The Institute of International Finance, a lobbying group for big banks, issued an influential argument along these lines, and the European stress-test results strongly suggest that European politicians do not want to press more capital into their financial system — just enough would be fine with them.

However, at another level — in terms of the analytical consensus around these issues — a great deal of progress has been made. In particular, an important new paper by Samuel Hanson, Anil Kashyap and Jeremy Stein, “A Macroprudential Approach to Financial Regulation,” pulls together the best recent thinking and makes three essential points. (This nontechnical paper, a draft intended for publication in the Journal of Economic Perspectives, is a must-read for anyone interested in financial-sector issues, but requires some effort as a little jargon does creep in.)

First, if we are really to apply the much-discussed new “macroprudential” approach to regulation, we need to get much more serious about capital requirements. In the past, regulators only cared if each bank — by itself — had enough capital to withstand likely losses. But experience over the last few years has made it clear that this is not enough.

The “macroprudential” view, articulated nicely in this paper, is that we should worry about banks being forced to dump assets in order to reduce their balance sheets — capital requirements are usually stated as the ratio of “capital” (ideally this would be shareholder equity) to total assets. Forced sales can cause asset prices to decline sharply — feeding into exactly the problems we saw in 2007-8, and eventually leading to the near-complete collapse of the market for asset-backed securities.

Individual financial institutions, however, do not care enough about the systemic effects of their actions — these costs are “externalities” to their decision-making. But from a social point of view this is a big deal and an important reason why the recession of 2008-10 was so severe. We should therefore have substantially higher capital requirements than heretofore — presumably far above what regulators currently have in mind.

Second, we should set capital requirements for types of assets — not, as is done currently, by types of lenders. Banks obviously have an incentive to “leverage up,” that is, to borrow more relative to their equity. If we regulate only banks, these same transactions will migrate to more shadowy parts of the financial system.

Probably the most innovative part of the authors’ proposals is that we should set much higher margin requirements against asset-backed securities. Allowing any entity — irrespective of what you call it — to borrow heavily against such assets is not a good idea. Unfortunately, this approach is completely absent from the current regulatory reform toolkit.

Third and perhaps most important for the continuing policy debate, the authors argue there is no evidence that increasing capital requirements — if handled the right way — would have significant adverse effects on the credit available to the nonfinancial sector or on economic growth and employment.

The consensus of policy makers is unfortunately in a different place on this — unduly swayed by the Institute of International Finance and other representatives of global banks. But Mssrs. Hanson, Kashyap and Stein are careful and categorical — shifting from debt toward more equity financing for banks would have, at most, a small effect on interest rates for loans. The Institute of International Finance and its allies are plainly and obviously wrong on this issue.

The authors are leading financial experts and, as a result, carry a great deal of weight in policy circles. Mr. Stein, a professor at Harvard, is former president of the American Finance Association and a sometime adviser to the Obama administration. Mr. Kashyap, a professor at Chicago, has written authoritatively on the financial rise and fall of Japan, among other things. Mr. Hanson is an up-and-coming graduate student at Harvard.

In this paper they do not spend much time explicitly on the political economy of capital requirements and the broader regulatory framework for banks in the United States or around the world. But implicit in their analysis is the sensible idea that banks and other powerful financial players are not passive “rule takers”; the finance industry has spent a great deal of time and treasure in recent decades undermining what these authors would regard as sensible rules.

And the same global banks are working hard to undermine the Basel process, so far to great effect. Mssrs. Hanson, Kashyap and Stein have helped move our thinking in the right direction. But the stark contrast between their views and the political and regulatory reality on the ground only highlights how much further we need to go.

 

 Simon Johnson, the former chief economist at the International Monetary Fund, is the co-author of “13 Bankers.”

With the final passage of landmark and pro-consumer federal financial regulatory reform, expanding community investment obligations to the entire financial sector represents the next major task necessary to a strong economic recovery. Now that a strong consumer protection agency is on the way to keep bad products out of the marketplace, it is critical to ensure that good products are available in every community – including low-wealth communities and communities of color. The Community Reinvestment Act (CRA) is critical to ensuring that good products are available in every community, but it needs to be modernized to make sure that it keeps pace with the rapidly-changing financial industry.

Why modernize CRA? Why now?

Fewer major bank mergers means that there are fewer opportunities for public debate on CRA performance, and an increasingly diversified financial industry means that too many financial institutions escape CRA obligations all together.

What would a modernized CRA look like?

We need a CRA that applies to not just banks, but also to the mortgage companies, insurance companies, and securities firms that conduct an increasingly large portion of their business in our communities. We also need to make sure that there are real incentives to keep financial institutions active in underserved communities, and make sure there are real penalties for those companies that fail to meet the financial needs of low-wealth people and communities within their footprint. Finally, we must ensure that financial institutions are sufficiently serving communities of color as well as low-wealth communities.

How can Chicago-region organizations get involved?

In July and August, there will be three opportunities to share your thoughts on how financial institutions can best serve low-wealth communities and communities of color.

1. Attend the upcoming workshop entitled “How To Prepare To Testify for A Stronger Community Reinvestment Act (CRA) At the Upcoming Federal Reserve Hearing.” This workshop is designed to facilitate a discussion with community organizations on the benefits of CRA, and help prepare written comments, oral testimony, or answer questions on why CRA modernization is necessary to their organization’s community investment mission. Tuesday, July 27, 2010 from 10am to 12pm PNC Bank 8700 S. Cottage Grove Chicago, Illinois To register, contact Otis Monroe at omonroe@themonroefoundation.org.

2. Participate in the “Chicago Region CRA Modernization Conference Call.” Hosted by Woodstock Institute, participants will learn why CRA should be modernized and what is being proposed. The call will also include information on how to register to attend the Federal Reserve hearings on CRA.

Tuesday August 3, 2010 from 10am to 11pm
Dial-in Number: 1 (605) 715-4920
Access Code: 995524#

To register for the call, contact Beverly Berryhill at 312-368-0310 or bhill@woodstockinst.org.

3. Attend the “Public Hearing on CRA Modernization” hosted by the Federal Reserve Bank of Chicago. The hearing will include testimony from policymakers, community organizations, and financial services leaders. Attendees not presenting oral testimony will have the opportunity to ask questions during several open mic sessions.

Click here to register to attend the public hearing. Registration must be processed by August 5, 2010.