In recent weeks we have been treated to several regulatory observations and preliminary decisions about the appropriate level of bank capital. A few comments have come from U. S. bank regulators. A major recent pronouncement came from the Bank for International Settlements, more commonly known by the name of the Swiss city where the bank is located — Basel.
Though the specifics vary, one theme persists — the regulators want to see banks holding more capital. That is not an uncommon response from regulators, nor entirely unjustified. From a regulatory perspective, capital is the buffer between weakness in a loan or investment portfolio, and the need for regulators to take action against the institution. The greater the capital (so it is commonly believed) the less likely regulators will need to take action against the institution. But there are other significant implications for regulatory determinations on capital adequacy. These determinations can, in a significant way, determine the direction of the banking industry for the next decade or so.
In an ideal world, the appropriate regulatory or statutory minimum capital level would be identical to what an economic capital model would determine. The classic definition of economic capital is the amount of capital required of a going concern to cover all risks including credit, market, operational, liquidity and other. In a truly efficient market, customers and creditors assess the adequacy of that capital level and make decisions on which businesses to support and which to avoid. Horizontal comparisons are made within the industry utilizing information readily available to the market and customers make choices based on that information.
Appropriate economic capital levels also vary by industry type, and by the relative barriers to entry for that business. In businesses with low barriers to entry and minimal regulatory requirements, there can be a wide range of capital and profitability levels. On the other hand, for businesses with significant regulatory oversight, but with accompanying legal barriers to entry - often described as an oligopoly — profitability is predictably within a narrow range. Public utilities typically are in this model.
The banking industry falls somewhere in between. Banks are heavily regulated, like utilities, but virtually every product the industry offers is also available in the unregulated — or shadow banking — marketplace. And while the capital markets focus on bank capital adequacy, bank customers typically do not. The primary reason, of course, is the impact of deposit insurance. As depositors (who also are creditors) are significantly covered by deposit insurance, the market risk to the customer has been largely removed. Customers select banks based on a number of criteria, but capital adequacy is a secondary concern for most depositors. Deposit insurance has been a welcome component of the banking industry as it has provided a level of stability for financial markets that did not exist prior to the establishment of the FDIC in 1933. The offset, of course, is that bank regulators substitute for market discipline in many ways — including a determination of capital adequacy.
In troubled economic times that include bank failures, the instinctive reaction of regulators is to press for increased capital. But regulators pressing for additional capital without acknowledging the importance of aligning regulatory capital with economic capital will have potentially serious implications. I have heard capital levels for banking compared with other industries without taking into consideration the financial models for businesses within those industries. Leverage ratios (debt/equity) vary significantly by industry.
In the restaurant industry, for example, a well run company is apt to have twice the amount of equity as debt. Even investment banks — often lumped with commercial banks in the minds of the public — will in some instances have three times the level of capital to assets as do typical commercial banks. Does that mean banks have historically been undercapitalized, or does it reflect a fundamental change in the need for capital among industries?
In determining an appropriate level of capital for banking, it is important to first recognize that the banking industry's function in the economy is that of a financial intermediary. Banks intermediate the translation of savings and checking accounts of depositors on one hand into funds available to borrowers on the other. By definition, that is a relatively low margin business.
In recent years the top financial performers among banks had net interest margins significantly under 5%. From that starting point, banks then add any revenue from fees and deduct all costs of running the business. Following the passage of Dodd-Frank, fee opportunities will be significantly diminished. The historic bank financial model has been predicated on 8% being a threshold amount that would allow for appropriate levels of safety and allow for a return on equity that will continue to attract capital. That historic 8% level has been creeping into the 10% range in recent years, without offsetting new product opportunities that would allow for either higher margins or less capital-intensive revenue streams.
In today's environment, there are a limited number of avenues to pursue improved bank profitability. Fee income opportunities have been reduced and banks cannot anticipate gains from equity appreciation as can the investment banks.
If regulators significantly raise capital level requirements, the fundamental bank financial model will change. It will require greater risk taking to achieve historic returns on investments, or it will relegate banking to a utility industry type financial status without providing the market access protections of a typical oligopoly. Hopefully these factors will be given consideration as capital adequacy decisions are debated.
Mark W. Olson has served as a Federal Reserve Board governor, chairman of the PCAOB and chairman of the American Bankers Association. He currently serves as co-chairman of Treliant Risk Advisors LLC and can be reached at
