Banks Won’t Cheer More Capital, but They Need It: Dwight Jaffee

Jan. 30 (Bloomberg) -- Not long ago, Washington policy makers, especially the Treasury and the Federal Reserve, were declaring the U.S. banking system safe from the throes of the subprime-mortgage crash.

One good sign: Most large banks were paying back their bailout loans from the government. The passing grades assigned to most of the same banks as part of the Federal Reserve’s stress test were another positive signal. Even those lenders receiving less than top assessments could access additional private capital to stabilize their balance sheets.

So it is striking that barely a day passes now without new public concerns for the U.S. banking system, let alone for European banks. Something is missing here.

An expanding group of academic financial economists worry that the banks still aren’t holding sufficient capital relative to their risks. They argue that the current capital requirements are inadequate, and that the new, higher standards set by Basel III, the international banking agreement, are also too lax.

The academics claim that the additional capital wouldn’t impose significant new costs on bank depositors or borrowers. The key to their position is that the enhanced bank safety that comes from the extra capital creates a value that exactly offsets the cost of this capital.

Dividend Yields

Two facts help clarify this proposition. First, banks are allowed to invest their capital in earning assets, so the resulting income can be paid back to the bank shareholders as dividends. Second, as a bank becomes safer, its investors can be more easily satisfied. Shareholders will accept lower dividend yields; bank bondholders will settle for lower interest rates. In short, greater bank safety has direct tangible benefits for the bank itself.

Bankers, however, firmly disagree, claiming that capital is expensive and that higher capital requirements will force them to charge higher loan interest rates. As one example, they note that banks must pay corporate income taxes on the earnings from additional capital, and that ultimately bank customers must pay for these costs. Banks also claim that higher loan rates will drag the economy down even further. These arguments appear to have been successful in deterring the government’s regulators from imposing new and higher capital requirements.

So who is right here? While the bankers’ unease is understandable, the academics’ big-picture perspective looks far more compelling. The bankers are correct that earnings from the additional capital will raise their corporate income taxes, and if the banking system is competitive, these costs must be passed through to customers.

The academic response is that these additional taxes will have scant impact. Perhaps they would raise a loan rate to 6.04 percent from 6 percent. In any case, there is nothing wrong with the banks and their customers paying the costs required to enhance bank safety.

The primary claim of the academics, however, is that the largest banks fight higher capital requirements primarily to protect their benefits from being deemed “too big to fail.” With TBTF status, a bank can maintain relative risky (and hopefully lucrative) investments without creating a significant backlash from bondholders and uninsured depositors.

The bondholders and uninsured depositors are unconcerned because they expect, if worse comes to worst, that the bank will receive a government bailout. For the academics, of course, eliminating TBTF status and the embedded government bailouts is the holy grail of successful banking reform.

While it is understandable why the academics and bankers fundamentally disagree over TBTF status, it is less clear why the regulators appear mainly to side with the banks on the capital issue.

Regulators’ Role

One possibility, of course, is that the overseers have been co-opted by the banks. While there may be some truth here, regulators generally do support the parts of the Dodd-Frank Act that create greatly expanded regulatory oversight of systemically important, or TBTF, banks. In this dimension, the issue is one of rules (capital requirements) versus discretion (oversight).

It is worth recalling that bank regulations before and during the subprime crisis had a firm rule titled Prompt Corrective Action. Bank regulators were to require a failing bank to promptly recapitalize or merge, or failing those, to close the bank. Alas, in the crisis, too big to fail trumped prompt corrective action.

The bottom line is that rules must be enforceable. Academics would conclude that higher capital requirements exactly meet this test.

(Dwight Jaffee, a professor of banking, finance and real estate at the University of California’s Haas School of Business, is a contributor to Business Class. The opinions expressed are his own.)

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