20 February 2013

Douglas J Elliott: Higher bank capital requirements would come at a price

A dangerous misconception appears to be taking root in the public debate about bank safety. A belief is growing that banks could be made much safer, at essentially no economic cost, by requiring shareholders to supply far more of the funding for banks with correspondingly less coming from debtholders and depositors. In fact, there would be significant economic costs, so there needs to be a debate centred on an examination of the trade-offs. Personally, Elliott agrees with the majority of analysts and policymakers that the costs would outweigh the benefits, but his key point here is that we need a debate on the trade-offs, wherever we come out on them.

The arguments start with a sound theoretical base, but important caveats and practical problems are dropped from the discussion somewhere in the transmission chain from the more careful academic studies to the popular discourse. This matters, because many of the simplistic proposals being aired would reduce lending and make what remains substantially more expensive. The recent severe recession is a reminder of how much damage a credit crunch can do, so we ought not to inflict one on ourselves voluntarily.

The proposals call for much greater levels of bank capital, mostly in the form of “shareholder equity”, which comes from the sale of common shares to investors in combination with bank profits that accumulate over time. Currently, common shareholders supply roughly 5 per cent of the funding for most banks, while the proposals often call for increasing this up to 30 per cent. A key attraction is that proponents frequently argue that this increase in capital is costless or nearly so, when measured properly.

Elliott argues that this is untrue, unless one assumes some major changes to law and public policy that are very unlikely to occur. Even if they do, there would remain quite difficult transition issues and a more permanent problem that the change would likely cause a massive shift of lending to less regulated sectors, reducing the benefits of the change, potentially to the point of making the financial system less stable in the aggregate, not more.

Once one accepts that there will be significant economic costs to sharply higher capital requirements, then a useful debate can take place about the right level of capital, given the trade-offs, and how best to achieve it. In fact, this is the debate that much of the policymaking and academic community has been involved in for some years, and to which I have contributed. Elliott's central point is that it is important not to be sidetracked by arguments that there is no real cost to the added capital.

The remainder of this paper discusses the issues at a fairly high level, both because of space limitations and to ensure the key points are understandable for a non-specialist. For those wishing more explanation, Elliott has included a list of his more detailed papers on this topic under References in the back. This includes a primer on bank capital, for those new to the topic.

Full article

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