Capital Cushions Against a Credit Crunch

Built up by stress-test offerings and solid earnings, capital levels at the nation's largest banks have been surging since the end of 2008 (see charts below), shooting well past official regulatory standards.

But the current benchmark might simply reflect the scale of what is needed in an enfeebled, unstable economy — a minimum to which policymakers should add another substantial buffer to avert a systemic contraction of balance sheets in the next crisis, a group of economists argued in a paper in July.

Setting out the case for macroprudential regulation, Samuel Hanson, a graduate student at Harvard University; Anil Kashyap, a professor at the University of Chicago, and Jeremy Stein, a professor at Harvard, wrote that current capital requirements are designed to keep deposit insurance schemes in balance.

If a bank is unlikely to rack up losses in excess of, say, 6% of its assets in between quarterly regulatory visits, capital in that amount is generally sufficient to sustain it until it is ordered to restore its finances. (Currently, the total Tier 1 regulatory minimum for "well capitalized" institutions is 6%.)

But society is also endangered by the tendency among troubled banks to try to bring ratios into line by dumping loans en masse — instead of raising new capital, as was mandated by the stress tests — thereby triggering a credit crunch that wrecks the economy and sets off a spiral of forced selling that intensifies the carnage. (Raising equity dilutes shareholders but shores up debtholders' position at no cost to them, creating a propensity to shed assets.)

The International Monetary Fund's estimate that cumulative losses at U.S. banks from 2007 to 2010 will equal 7% of assets offers one benchmark for the size of a firewall that could be burned through without impairing lending activity, the economists wrote. If market forces have now compelled Tier 1 common equity ratios of 8% to 10% at giants like Bank of America Corp. and Citigroup Inc., then ratios of about 15% could be suitable for good times.

The economic impact of higher capital ratios has been hotly debated. An assessment by the Basel committee is to be released this month. The Institute of International Finance, a trade group for international financial companies led by Josef Ackermann, the chief executive of Deutsche Bank AG, projected in June that the Basel proposals as they then stood would reduce economic growth in the United States by about 0.5% a year from 2011 to 2015 because banks would increase lending rates to offset higher funding costs, thus restricting the flow of credit. (The institute noted that it had not sought to estimate the benefits of stronger rules, which it said could "probably best be measured in terms of stability gains.")

Using a model that balances loan pricing against bank funding and credit costs, Douglas Elliott, a fellow at the Brookings Institution, has reckoned that ratios of tangible equity to assets could rise four percentage points, to 10%, with an associated increase of only 20 basis points in lending rates, to 5.37%, if debt funding costs fell 20 basis points, to 1.8%, and equity investors' requirement for returns fell one percentage point, to 14%. (Other factors in the equation, like administrative costs, would also have to move modestly.)

Economic theory holds that a reduction in risk based on lower leverage should bring down the cost of equity, though factors like differences in tax treatment (interest expenses reduce taxable income) that make debt cheaper dampen the offset.

Looking to history as a guide, Hanson, Kashyap and Stein did a series of regressions on about a century of data for U.S. commercial banks and found statistically insignificant relationships between equity-to-assets ratios and net interest margins and the difference between loan rates and deposit rates.

They did find a statistical correspondence between equity-to-assets ratios and the gap between the prime rate and the yield on Treasury bills but dismissed it as "too big to make economic sense" and concluded that the record "is too noisy, and our proxies for loan spreads too crude, for us to draw any confident conclusions about whether a correlation between equity ratios and loan rates even exists."

Still, the pull of leverage is intense in banking, the economists wrote, as marginally cheaper funding can confer a decisive advantage to one bank in competition with another.

Small banks, meanwhile, have typically operated at much higher capital ratios than larger ones, probably because their "focus on informationally intensive 'relationship lending' " to small customers makes differentials in funding costs less important.

At the same time, small banks demonstrate that high capital levels do not necessarily translate into unworkable loan pricing, and tougher standards "seem to hold the promise of reducing competition on a dimension that creates negative externalities and systemic risk, while at the same time not raising loan rates by much."

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