Do Banks Know What It Takes to Be Safe?

Banks complain about capital requirements, but a Fed report suggests they don't really know how much capital they need.

The largest U.S. banks regularly claim that higher capital requirements would present a threat to the economy. Judging from a new report from the Federal Reserve, the real danger might be banks' own inadequate grasp of how much capital they really need.

Efforts to build a more resilient U.S. financial system have lately focused on bank capital -- equity from shareholders and other forms of financing that, unlike borrowed money, can easily absorb losses and prevent insolvency in times of crisis. Regulators have proposedthat banks fund each $100 in assets with at least $5 in capital, while others have suggested that the minimum capital requirement be raised to $15 or more per $100 in assets.

Advocates of higher capital levels, includingBloomberg View, argue that they're crucial to maintaining banks' ability to keep credit flowing even in tough times and to protecting the broader economy from bank managers' mistakes. Banks counter that the proposed requirements would be excessive and inhibit the lending needed to keep the current economic recovery going.

The Fed report pokes a hole in the banks' argument, noting that in many cases banks don't actually have a very good idea of what "excessive" capital would be. Without naming specific institutions, the report finds numerous deficiencies in the capital-planning practices of the largest U.S. banks. (Not very soothingly, it also points out that the current practices represent an improvement over the past.)

Consider, for example, risk modeling -- the process of estimating potential losses that went so spectacularly wrong in the London Whale trading fiascoat JPMorgan Chase & Co. According to the report, some big banks didn't even have a full accounting of all the models they used to estimate their potential capital needs: "They also did not formally review all of the models or assumptions used for capital planning purposes (including some high-impact stress-testing models)."

Other flaws included "antiquated" or "siloed" risk-management systems that provided an incomplete picture of a bank's many businesses, overly optimistic assumptions of potential losses, poor reporting to the corporate boards that are supposed to oversee risk, unrealistic emergency plans and much more. According to the report, every large bank "faced challenges" in at least one important area.

Given the difficulties banks seem to encounter in estimating their capital needs, it would be prudent for regulators to err on the high side in setting minimum requirements. Researchsuggests that within the range currently under consideration, the benefit of a stronger financial system will far outweigh any negative effect on lending. If banks want to argue otherwise, the burden of proof should be on them.

This column does not necessarily reflect the opinion of Bloomberg View's editorial board or Bloomberg LP, its owners and investors.