Let’s Kill the “Bank Capital Kills the Economy” Talk

Tim Congdon and Steve Hanke have just argued in a Wall Street Journal op-ed that further increases in bank capital would kill the economy…

Tim Congdon and Steve Hanke have just argued in a Wall Street Journal op-ed that further increases in bank capital would kill the economy. Funny enough, FDIC Vice Chairman Thomas Hoenig offered a rebuttal, during a speech earlier in the day:

As you know better than anyone, there is significant opposition to raising capital especially for the large, complex, universal banks. Primary arguments are that doing so would hamper lending and that current capital requirements are already too burdensome and have been a drag on the economy. These assertions are incorrect. Data show that a higher level of tangible equity in banks does not curtail lending, but promotes it. Capital does not remain idle. Along with debt, capital is a primary source of funding for lending. As tangible equity grows from retained earnings, lending and earnings continue to grow. As capital levels have increased since 2009, albeit too little, loans have increased by $2.1 trillion, or 4 percent a year on average, and bank earnings have continuously improved. Further, studies document that insured banks with higher levels of tangible equity are more likely to lend through economic cycles, including a downturn, which helps sustain economic growth over the long term.

John Cochrane offered his quick rebuttal, too. I see other things not to like.

First, their “sample” begins in the 1930s. If you do that, it looks like today’s capital ratios have returned to the “historical highs” of the 1930s. But if you have a look at the longer view (see, for instance, Figure 2 here), you’ll see that today’s ratios are still well below levels observed in the 19th century.

Second, they offer the 1950s and 1960s as a good reference point for bank regulation and performance — but do we really want to return to a world when banking services were available only between the weekday hours of 9 and 3? In a pre-1980s context, perhaps the 1950s and 1960s offered promise relative to what was happening in the 1930s, as Federal Reserve Bank of Richmond senior economist and policy advisor John Walter wrote about in 2006. But that’s still no model of the future.

Finally, let’s for the sake of argument accept that “equity is expensive”. In a recent paper my co-author and I show that if banks were to pass off those higher financing costs to borrowers, the benefits of raising the equity-to-asset capital ratio from 4 to 15 percent still almost always equal or exceed the costs. You have to make unrealistic assumptions to get the costs to exceed the benefits.

If you further increased regulatory capital ratios to the point where the marginal benefits equaled marginal costs, on average that would be around 23 percent. Why’s that important?

John Cochrane sums up his rebuttal nicely: If banks had 20 percent capital going in, there would have been no crisis, and no bailouts, because no bank would have gone under.