Bank Leverage, Regulatory Capital, and the Illusion of Safety

The market no longer determines what is adequate capital for the banking industry. Following generations of taxpayer support and government involvement, politicians, regulators, and lobbyists have supplanted the market in determining what counts as capital, how it is calculated, and how much is enough. This artificial mechanism has resulted in a decline of both the level and quality of capital among the world’s largest banks. Michael Barr, Vice Chair for Supervision at the Federal Reserve (Fed), recently initiated a holistic review of current capital standards, noting that while bank capital levels have improved, they remain too low. His statement was hardly complete before Securities Industry and Financial Markets Association (SIFMA) and other industry lobbyists began criticizing such a review as unnecessary, arguing that capital levels for the largest banks are extraordinarily robust, adding the necessary caveat “relative to their pre-financial crisis levels.”

Because the regulators have supplanted the market in setting bank capital standards, they increasingly rely on ever more arcane and complicated methods to determine how much capital a bank should hold. They assign risk weights to the different asset categories held by banks. The weights are determined relying on a combination of regulatory judgement and highly complex algorithms. In nearly every instance, the risk-adjusted size of the balance sheet can be manipulated. If a bank holds government securities, collateralized debt obligations (CDOs), mortgages, or other assets that regulators deem less risky than, say, commercial loans, a bank, for capital purposes, can adjust its asset balance to less than 100 percent of book value. A bank with $1 trillion in total assets and $50 billion dollars of equity capital would report a capital-to-asset ratio of only 5 percent, indicating $1 of capital supported $20 dollars of assets. But as the bank manages its portfolio to include assets that the regulators “judge” less risky than loans, it can shrink its balance sheet by as much as half. Under this measure its capital-to-risk-assets ratio would be 10 percent, and the institution would appear less leveraged. Such a difference can be significant not only in its calculations but in its implication for a bank’s ability to absorb unexpected losses.

In the financial crisis of 2008, the risk-based capital program failed terribly at measuring the industry’s financial strength and sustainability. Almost immediately upon the emergence of the crisis, investors were unable to use the risk-based capital measure to judge the viability of the firm. Assets such as CDOs were riskier than its loan book and experienced far greater losses than the risk weighting anticipated. Today, this is again happening as interest rates have increased rapidly and banks are reporting billions of dollars in unexpected unrealized losses. In such instances, investors necessarily turned to the simpler more reliable equity-to-total-assets ratio to know how much capital is available to absorb losses before insolvency.

The poor performance of the risk-weighted capital program during the crisis should have made clear that the real policy issue regarding capital is the importance of equity and the effects of leverage on a bank’s resilience during financial stress. The greater the leverage the higher the returns to equity but also the greater the risk of insolvency should an economic recession or crisis develop. And since the market is no longer responsible for making this judgement, the process has become political. While the industry has prevailed in keeping the risk-weighted measures as the principle means for setting capital levels, the regulators should learn from their mistakes and stop it.

It is alarming that as the Fed raises interest rates and the risk of a recession has increased significantly, the largest bank lobbyists are campaigning against a holistic review of capital measures and standards. They cite any number of studies suggesting that strong capital raises the cost of borrowing, and they point specifically to its damage to small business. They quote studies that suggest borrowing costs might rise by a quarter percentage point and reduce economic growth by hundreds of billions of dollars. However, these lobbyists neglect to note the many more academic studies that show that higher capital standards reduce the likelihood of financial crisis and, under a reasonable cost-benefit test, show that stronger capital enhances financial and economic stability and over the long run delivers stronger and more consistent economic growth.

A study by the Federal Reserve Bank of New York, for example, found that growth of the bank capital ratio reduces the risk of a sharp decline and speculative acceleration in GDP growth, a relationship that is particularly robust in reducing the probability of the worst GDP outcomes. These results suggest a role for stronger capital to mitigate financial crises, pointing out that an additional 100 basis points of bank capital reduces the probability of negative GDP growth by 10 percent at the one-year horizon, even controlling for credit growth and financial conditions. A second study by economists at the Mercatus Center at George Mason University also found a significant net benefit to financial stability and economic growth related to having a capital-to-asset ratio in the range of 15 percent. A paper presented at a Federal Reserve Bank of Kansas City symposium, provided a detailed analysis of both the usefulness of the equity-to-asset ratio in comparing relative capital levels among banks and the fact that banks with higher equity capital levels performed consistently better than those holding less capital. These studies recognized that increases in capital standards would raise the public’s cost of borrowing modestly, but their analysis showed clearly that the stronger capital levels enhance bank stability and over the long run support stronger economic growth.

Finally, researchers at the Bank of International Settlements in its study on this issue found that a bank with plentiful “own funds” (equity capital) can attract creditors at lower costs and on better terms than a less well-capitalized bank. It emphasized that both the macroeconomic objective of unlocking bank lending and the supervisory objective of sound banks are better served if banks have more capital. Sound banks lend more and do so on a sustained basis over the cycle. It found, for example, that a 1.0 percentage point increase in the ratio of equity-to-total-assets is associated with a 0.6 percentage point uptick in subsequent growth in lending.

The largest banks’ lobby often asserts that because they were so well capitalized during the pandemic, they readily withstood the financial turbulence emanating from that period. An alternative explanation for the industry’s resilience is that because it was a health crisis, the government and Fed intervened immediately and substantially, bailing out borrowers, capital markets, and consumers well before a health crisis became a banking crisis. It is incredible that the industry would use that event as a justification for weakening capital standards in its funding and stability goals.

By contrast, the absence of the largest banks having sufficient equity capital as they entered the Great Recession required governments to infuse public funds into many of them. It will be at significant public cost if that lesson must be relearned should bank capital weaken. Balance sheet strength matters, equity matters, and it is not credible to base public policy on the position that in the short run high leverage accelerates economic growth, given that overwhelming evidence shows that leverage balanced with strong capital means stronger, safer economic growth. Bank performance through the entire cycle is what matters for sustainable growth. The largest banks fund less than 6 percent of their assets with investor capital and this is a prescription to repeat the mistakes of the past.