Scoring the Great Debate Over Capital Rules
Ten years since the financial crisis and with the world economy in recovery, global policy makers who gathered in Washington for the annual meetings last week have finally found a moment to reflect on what they have achieved. So vivid are the memories of the crash, that the most pressing question is whether the new rules put in place to strengthen the financial system are adequate or need to be toughened further.
Ask most academics and the answer you’ll typically get is that banks should hold more capital than is currently required. Not only is a bank with higher equity more stable. It is also able to lend more to families and businesses, since it can leverage that capital into new loans. This line of reasoning is anathema, however, to most bankers. At a conference held by the Peterson Institute for International Economics on the future of macroeconomics, Lorenzo Bini Smaghi, chairman of Société Générale S.A., the French bank, summarized that point of view rather well, saying that “higher capital has at least in the transition made credit more difficult.”
Helpfully, the International Monetary Fund has taken a deep dive into these questions. The latest Global Financial Stability Report has a section on global systemically important banks and how they have changed since the financial crisis. The IMF finds that mega-lenders have collectively raised $1 trillion of fresh capital since 2009. Fund officials believe this process may have affected lending in the short-run, but over time banks have been able to adapt.
Tobias Adrian, the IMF Financial Counsellor, told me in an interview that it's important to note the distinction between short-term and long-term effects. “In the short term, if you move around some of these buffers that have been introduced, that might have more of an impact on the cost of credit,” he says. “In the longer run, banks can adapt to these different levels of capital requirements, and I would expect these effects to be neutral.”
His view is consistent with the one presented by Andrew Haldane, the Bank of England’s chief economist, in his talk at the same PIIE conference. Haldane compared the capital ratios of international banks prior to the crisis against their subsequent rate of lending growth: He found that banks that entered the crisis in a stronger position were better able to continue to extend loans. In particular, each extra percentage point of capital raised cumulative lending over the subsequent decade by more than 20 percent.
However, Haldane too recognizes that there may be a short-term penalty to raising new equity. He finds that banks that have increased their capital ratios by an extra percentage point have extended 4 percent less credit since the new “Basel III” rules were introduced, strengthening bank capital requirements. At least in the short-term there seems to be a trade-off between making banks safe and encouraging them to lend.
What about profitability? This question does not matter solely for shareholders, but for society as a whole. Banks that are unable to generate profits are more likely to get into trouble. Retained earnings are a sustainable source of future capital, which in turn allows a bank to be more stable.
The IMF found that while profitability has diminished severely in the aftermath of the crisis, there is now no long-term link between how robust a bank is and how much money it can make. What matters is the ability to cut costs – such as redundant branches - and find sustainable revenue streams. For globally systemically institutions, the Fund found no relationship between expected capital levels in 2019 and expected profitability in that same year.
“Some people are of the notion that when you demand higher capital, then of course return on equity is lower, but you can see that across banks that’s just not the case,” says the IMF’s Adrian. He goes on to explain that in good times, higher capital requirements may mean lower profits. On the other hand, the additional capital proves beneficial in bad times, when running out of capital is costly.
Both academics and corporate leaders have a point. Higher capital requirements appear to weigh on lending and profitability in the short-run, but these effects disappear as time goes by. Which side policy makers decide to team up with will ultimately depend on how forward-looking they want to be.
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Therese Raphael at firstname.lastname@example.org