Until small businesses share in the economic recovery, there won't be enough private-sector employees paying income taxes to start reducing the federal deficit. Small businesses created nearly 65% of new U.S. jobs during a 15-year period. These openings resulted from thoughtful management, hard work and, in many cases, loans from community banks. In 2009, Sen. Jeff Merkley noted that community banks "hold 11% of total industry assets but make 38% of small-business and farm loans." Now these loans and openings are fewer because, in the recent downturn, federal banking regulators ordered many community banks to reduce their total assets per dollar of equity capital.
Federal "leverage ratio" orders require Tier 1 (equity) capital as a percentage of a bank's total assets. Unlike "risk-based" capital requirements, leverage ratio requirements treat all assets alike, regardless of predicted or proven risk and regardless of variations in risk management capabilities. These orders restrict bad old assets and good new assets, risky loans and safe loans.
Treating all loans alike unnecessarily harms small businesses. They generally haven't defaulted on their loans. Most of them didn't obtain the commercial real estate or construction loans that provoked the issuance of the orders requiring greater capital. Thus, most are innocent bystanders, but high administrative expenses keep their loans from generating strong returns. They cannot qualify (and often are categorized as having "weak credit demand") under the standards needed for adequate returns on capital, when regulators require excessive capital.
Regulators avoided an excessive requirement in 1992. They determined that a "well-capitalized" bank could have a "leverage ratio of 5% or greater."
Joe Peek and Eric Rosengren (now the Federal Reserve Bank of Boston's chief executive) confirmed that higher requirements hurt small businesses. In "Bank Regulation and the Credit Crunch" (1993), they demonstrated that federal orders requiring a "leverage ratio, usually 6%," had a statistically significant adverse effect on the availability of credit for New England's small businesses.
This year, the Dodd-Frank Act prescribed a higher leverage capital requirement for a nonbank company that "poses a grave threat to the financial stability of the United States." The act would require a "debt-to-equity ratio of no more than 15 to 1" — equivalent to a 6.25% leverage ratio of equity to assets.
The Basel III capital maintenance requirements are percentages of "risk-based" assets, not total assets. The Basel Committee on Banking Supervision will merely "test" (measure and monitor) a 3% leverage ratio that may become a Basel capital maintenance requirement by 2018.
Since 2008, however, the Federal Deposit Insurance Corp.'s San Francisco regional office has issued 36 orders requiring much higher Tier 1 capital at banks in our home states. The 30 orders in Washington each required at least 10% Tier 1 capital, and the six in Arizona averaged 10.2%. To comply with a 10% requirement, a bank can hold no more than $10 of assets for each $1 of equity.
Of those 36 banks, 30 had less than $1.5 billion of assets and only one had more than $10 billion. They cannot lend like big banks, whose lower capital requirements allow profits from more lucrative activities to cross-subsidize small-business lending. Small-business credits have increased at JPMorgan Chase Bank, whose Sept. 30, 2010, leverage ratio of 6.26% allowed $15.96 of assets per dollar of equity. If allowed 6.26% leverage ratios, community banks could make more small-business loans.
What justifies requiring 10% leverage capital in community banks, since economists found 6% requirements hurt small businesses, Dodd-Frank requires 6.25% for "a grave threat to the financial stability of the United States" and Basel's 3% leverage ratio is only a test? Trouble with some assets should not justify requiring a 10% cushion for all assets, unless management deficiencies affect all assets.
Regulators can examine a community bank's entire operations. If they identify deficiencies in risk management for assets in a certain category, posing a grave threat to the financial stability of the bank, then exceptionally high capital suits the assets in that category only. Before requiring such capital for other assets, the regulator should need to specify deficiencies in risk management affecting those other assets.
In last year's law allocating $30 billion in U.S. Treasury funds to invest in community banks (if they commit to pay 9% dividends after the first four and a half years of the investment term), Congress criticized the interaction of "regulatory capital requirements and lending standards, which is a contributing cause of decreased small-business lending." As protection against this cause, Congress should prescribe that deficiencies affecting all assets must be specified to validate ordering any community bank to exceed 8% "leverage" capital.
Rather than protect banks, excessive "leverage" capital requirements cause collateral damage that undermines the whole economy, ironically including banks. Credit crunches keep small businesses from hiring. Prolonged macro-level unemployment may force the economy through structural changes, undermining the demand for commercial real estate and endangering banks that made commercial real estate loans. Requiring high capital for all assets imperils banks and small businesses' years of thoughtful, hard work. Foreseeing these risks, bank regulators should adjust capital requirements without waiting for remedial legislation.
