Free Markets Told Us How Much Capital Banks Need

James Greiff is an editor for Bloomberg View. He was Wall Street news team leader at Bloomberg News and senior editor for Bloomberg Markets magazine. He previously reported on banking for the St. Petersburg Times and the Charlotte Observer.
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Almost everyone, except maybe certain bankers and those in their service, thinks that banks should have more capital. A thicker capital buffer, as Stanford professor Anat Admati wrote a few days ago, would make banks more resilient in the face of losses, reduce the risk of a financial panic like we had in 2008-2009, and lower the odds that taxpayers will be called upon to prop up lenders deemed too big to fail.

The question, of course, is just how much more? Whatever the right answer might be, it surely exceeds anything federal regulators have recently proposed or bankers might be willing to support. The latest U.S. plan calls for boosting capital to $3 for every $100 in assets (and more for bigger banks), undoubtedly not enough to withstand another meltdown.

Saying just how much capital is enough is muddled by the labyrinth of public subsidies that make banks seem less risky than they actually are. By masking risk, the subsidies let banks operate with less capital than they otherwise might need in an undistorted market.

But let's do a bit of crude risk adjustment and strip out some subsidies. The big, easily identified ones are the Federal Reserve, which serves as the lender of last resort for banks that have been deserted by their short-term creditors; the Federal Deposit Insurance Corp., which shields small depositors against losses in the event of a failure; and the policy of bailing out banks whose collapse might destroy the financial system. All help prevent banks from going out of business, serving as a regulatory substitute for capital and offering protection accorded to almost no other industry.

Of course, just pretending these subsidies don't exist isn't possible. But there is a clear historical record of how much capital banks once had before too big to fail (roughly 1984, when Continental Illinois was bailed out), the FDIC was established (1933) and the Fed was created (1913). This shows that from the end of the Civil War up until the creation of the Fed, U.S. banks tended to maintain capital that ranged from 20 percent to 35 percent of assets.

Now it is true that U.S. banks of that era were different from our modern mega-banks. One reason banks held so much capital is the manner in which they funded their liabilities, while also providing backing to the nation's currency. What's more, there was nothing like today's deep and liquid capital markets, which let banks quickly borrow to plug any funding gap. But it also was an era in which banks couldn't count on taxpayer support, operating in an environment that's about as close to a laissez-faire laboratory as you're going to find.

Nor were financial panics unknown in this period, which is the reason the Fed and, later, the FDIC were established. One thing this look back does is offer yet another rebuttal to the recurring objections bankers raise when pressed to run their businesses with additional capital: More capital will raise banks' costs, they say, forcing them to charge more for loans and acting as a drag on the economy -- something we don't need in the midst of a lackluster post-crisis recovery.

This was a point David Miles, a member of the Bank of England's Monetary Policy Committee, tackled in 2011 when he looked at historic capital levels in U.S. and U.K. banks:

In the UK and the US banks once made much greater use of equity funding than they do today. But during that period, economic performance was not obviously far worse and spreads between reference rates of interest and the rates charged on bank loans were not obviously higher. This is prima facie evidence that much higher levels of bank capital do not cripple development, or seriously hinder the financing of investment.

The U.S. can't have a functioning banking system without the subsidies inherent in the Fed and the FDIC, and so far no one has a realistic idea for how to end too big to fail. But making banks carry capital of as much as 20 percent -- as they once did, and as Bloomberg View has called for -- would shift some of the subsidy costs from the public back to the industry.

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

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