June 10 (Bloomberg) -- Not long ago, U.S. Treasury Secretary Timothy Geithner described the key ingredient in a sound global financial system: “Capital, capital, capital.” He’s right about the ingredient. But when it comes to the world’s banks, he and his international counterparts are all wrong about the proportions.
Capital is the amount of money, or equity, that a bank’s shareholders put at risk -- like a down payment on a house. It’s also the simplest way to protect the economy from the risks big banks naturally take. The more capital banks have, the less likely they are to go bankrupt and trigger crises like the one the world is still recovering from.
As soon as this summer, global regulators will decide how big a down payment to require of banks large enough to present a systemic threat if they failed, a category that could include more than two dozen global financial firms. U.S. officials are aiming for a maximum of 10 percent, compared to a 7 percent minimum other banks must meet by 2019.
Bankers are already warning of dire consequences. If we want a safer system, they argue, we’ll have to pay for it. More capital means higher costs, which banks would pass on to customers in the form of higher interest rates on loans. That, in turn, could stunt economic growth by making companies less willing to invest and expand, as Jamie Dimon, chief executive officer of JPMorgan Chase & Co., warned earlier this week.
Logical as the bankers’ argument seems, it’s not quite right. The available evidence suggests that the benefits of fewer banking crises would far outweigh the costs of capital requirements much higher than those currently on the table.
Consider, first, the idea that capital takes a toll on economic growth. The bank-funded Institute of International Finance asserts this would happen. Its conclusion isn’t supported elsewhere. Three Bank of England economists, for example, looked at more than 100 years of data and in a January study found no clear link between capital levels and economic growth in Britain. Other studies have found that significantly higher capital levels would push up lending rates, but no more than 0.8 percentage point, and could move them as little as 0.1 percentage point.
The benefits of more capital, by contrast, can be considerable. When banking panics cause credit to dry up and companies to fire their employees, much of the lost economic growth is never recovered. The value of avoiding such losses, let alone the human suffering, is so great that the Bank of England team put the optimal level of capital at about 20 percent. A report from the Bank for International Settlements, the central bank for central bankers, pegged the ideal level at about 13 percent.
Transparency is almost as important as capital levels. Over the years, the banking system has become so complex that figuring out one large bank’s capital ratio recently required more than 200 million calculations, according to Andrew Haldane, executive director for financial stability at the Bank of England.
Global capital rules allow banks to place different weights on different kinds of assets, leaving them vulnerable to manipulation and mistakes. Technical errors alone, Haldane estimates, can skew banks’ estimates of their capital ratios by several percentage points -- a big problem if the starting point is only 10 percent.
Regulators worry that if they’re too tough on banks, they’ll create an incentive for bankers to find ways around the rules. Their concern seems misplaced. The off-balance-sheet machinations at the center of the recent crisis emerged at a time when capital requirements were as low as 2 percent.
The developed world is in no condition to take chances with banks. The average total debt of the U.S., Britain, Japan, and other advanced nations last year was 74 percent of annual economic output, more than triple the level in 1970. They can ill afford another major bailout. That leaves capital as the only barrier between taxpayers and an outcome far worse than whatever slightly higher interest rates might produce.
It’s hard to know what the perfect capital ratio is. But given the lopsided risks, it would be wise to err on the high side. The burden of proof rests on global regulators to justify why they aren’t aiming for a capital ratio closer to 20 percent.
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