More Capital Regulation or Just More Capital?

[Note: On 9/24/2024, I corrected the last sentence in the second to last paragraph to add an omitted “not” and added a missing hyperlink to John Cochrane’s Toward a Run-free Financial System in the last paragraph.]

This past Tuesday, the Brookings Institution hosted Federal Reserve (Fed) Vice Chair of Supervision, Michael Barr, who spoke about progress on the US Basel III Endgame revisions, given that the last version faced much resistance within the Fed and beyond. Vice Chair Barr’s genteel nature was evident during the question & answer period after the 24 minute mark, when he began by saying “life gives you ample opportunity to learn and relearn the lesson of humility.” Yet, soon after critics were already voicing their displeasure about the revisions implying Wall Street won. However, the question is, do we want more bank capital regulation, or just more bank capital?

In a post last year, I raised concerns about how much more complex the regulatory code for bank capital might become after Basel III Endgame. After all, when you add to what’s already there, that means even more resources devoted to hiring accountants, consultants, lawyers and quants to comply with the regulation and fewer resources for those seeking credit. While my rough calculations will admittedly be off, I suspect US Basel III Endgame will add a non-trivial amount of words to the existing body of complex capital regulation, which currently exceeds 20 percent of all regulatory word counts in Title 12 of the Code of Federal Regulations. Yet, it’s not the extra regulatory word counts that keeps banks from failing, but the extra equity funding banks use to keep away from default.

To see what I mean, Sergio Correia, Stephan Luck and Emil Verner have a new National Bureau of Economic Research working paper out, which looks at the causes of banking crises for all available US commercial banks from 1865-2023; this follows an earlier paper that Verner wrote with Matthew Baron and Wei Xiong, which showed that banking crises in 46 countries since 1870 tend to follow bank equity declines, not bank runs. These papers, among numerous others, suggest that insolvency, measured by capital-to-asset ratios are the best predictor of banking crises, not bank runs. If so, don’t Basel capital adequacy ratios take care of that? Not really.

Yes, bank reported Basel capital ratios look high, especially for the largest banks. Just check out the Kansas City Fed’s Bank Capital Analysis page. If you look at the most recent report, the Tier 1 Risk-Based Capital Ratio (Tier 1 Capital divided by Risk-Weighted Assets) for the largest US Banks on average equals just under 15 percent. But when you look over to the next column for the Tier 1 leverage ratio, you see the average for the same group of banks is less than half that amount. What’s the difference?

With the equity-to-asset leverage ratio, for a given amount of assets, the ratio’s higher if the bank actually funds with more equity. Anat Admati and Martin Hellwig have suggested a ratio in the 20-30 percent range would work well and my co-author Jim Barth and I have found those values are plausible. With risk-based capital ratios—and there are actually too many ratios beyond the Tier 1 ratio that I won’t discuss here—a bank can actually increase the ratio by either funding with more equity, or increasing holdings of assets that the Basel rules say require less capital (or some combination of the two). That means, you don’t actually know if a bank’s well capitalized by looking at the risk-based ratio, because you don’t know for sure what’s in the denominator of the ratio. That was true in the run up to 2008 and in the run up to the Spring 2023 bank failures.

For these and other reasons, former Federal Deposit Insurance Corporation (FDIC) Chair William Isaac suggested that the US should withdraw from Basel on Monday. Keep in mind that when Isaac served as FDIC Chair, regulators did not explicitly state regulatory minimum equity-to-asset capital ratios, which were around 5 percent. Right now, based on what I reported above, the largest banks only fund with roughly 1-2 percentage points more capital than they did in the 1980s (at least smaller banks operate with roughly double the average during the 1980s). That means considerable political effort has been expended in the US with very little change to minimum capital requirements for the key intended targets of Basel. Why?

Ethan Kapstein’s essay and longer book show how the 1982 Latin American Debt Crisis spurred Congress to pass the International Lending Supervision Act of 1983, which had the aim of getting banks to fund with more than 5 percent equity capital. The end result was the 1988 Basel Accords, which through a complex (and politically triumphant) process resulted in a global capital guideline minimum of 8 percent. However, to get that agreement, the six-page act prompted regulators to adopt risk-weighting, which requires those hundreds of thousands of extra regulatory words and opaque notions of capital adequacy. Moreover, they would not have to change their leverage ratio by much to satisfy the new “higher” capital requirements.

One way to ensure that we have well-capitalized banks is to have a minimum equity-to-asset leverage ratio equal to 15, 20 percent or more, for all banks. Another, related option would be to have banks fund their risky loan and other asset purchases with equity, while backing customer deposits with US Treasuries. These are the sorts of policy options that translate into proper credit allocation and financial system stability.