Radar |
Nov 4 , 2023
By Raghuram G. Rajan
While higher capital requirements can theoretically enhance stability by providing a cushion against losses and reducing the likelihood of bank runs, such requirements do not necessarily curb risk-taking, as evidenced by smaller banks engaging in risky commercial real estate lending. A certain level of capital requirement is necessary to prevent panic and loss. Still, regulators must find a balance in capital regulations to ensure safety without hindering financial activity, argues Raghuram G. Rajan, a professor of Finance at the University of Chicago Booth School of Business, in this commentary provided by Project Syndicate (PS).
Partly in response to the banking failures of March 2023, US regulators now want to impose higher capital requirements on banks with over 100 billion dollars in assets. But this is a puzzling choice, considering that some of the most egregious risk-taking recently has been found among smaller banks.
Some of the proposed changes – such as requiring banks to include unrealised gains and losses from certain securities in their capital ratios – are overdue. By and large, however, CEOs of large banks are not pleased. Jamie Dimon of JPMorgan Chase, for example, has blasted the proposal for stricter capital rules, warning that it could prompt lenders to pull back and thereby stymie economic growth. Before we dismiss such outbursts as self-serving “bankerspeak,” we should ponder the role that bank capital serves and whether regulators are moving in the right direction.
Long-term “patient” financing, such as equity, counts as bank capital. Unlike demand deposits, it does not have to be paid back in the short run.
If banks can be brought down by uninsured depositors rushing for the exit, is it not obvious that more capital means fewer runs, and thus a more stable banking system?
Unfortunately, the problem is more complicated than that. Yes, if we have two equally risky banks, one with more capital financing than the other, the one with more capital has a higher probability of survival. But we cannot assume that these two institutions will take the same risks, nor can we ignore the consequences of higher capital requirements for overall financial stability and the economy.
Obviously, more financing through capital issuance reduces run-prone borrowing (bank leverage). It also provides a loss-absorbing buffer; since banks’ losses will have to eat through capital before reaching depositors, banks can withstand small accidents. Supervisors will have time to react if they see bank capital eroding. With supervisors also demanding that banks hold capital in proportion to the risk of their activities, capital serves as a budget for risk-taking.
Because investments in bank capital are very sensitive to bank risk, a minimum capital requirement acts as a kind of entry ticket: only banks that can convince investors that they will not take undue risks can raise capital at a reasonable cost. And since banks typically generate capital through retained profits rather than new equity issuances, capital regulation allows profitable banks to grow while restraining loss-making banks. Finally, given its importance, the level of a bank’s book capital gives the public a way to gauge its performance.
These are all good reasons for regulators to insist that banks hold reasonable amounts of capital. Before the 2008 financial crisis, some banks operated with capital as low as two percent of assets, making them accidents waiting to happen. In contrast, big banks came through the March 2023 episode relatively unscathed, though other regulations clearly helped.
The question, then, is whether raising capital requirements is appropriate today.
We can immediately dismiss one rationale for doing so: capital gives a bank’s board (or the equity holders they represent) more skin in the game, thus a greater incentive to limit risk-taking. Anyone who has served on the board of a large bank knows that board members are entirely dependent on what they are fed by management. It is a pipe dream to think they will restrain a cowboy executive team. As the US Federal Reserve’s report on the collapse of Silicon Valley Bank (SVB) shows, sometimes even supervisors are unaware of the risks a bank is taking, or are unable to stop it when they see it.
Capital regulation often fails to limit a bank’s pursuit of tail risks that earn profits in good times. Those earnings will add to its capital and allow it to take more risks – at least until the bad times come.
Finally, as more capital gives bank management a longer leash, higher capital requirements may come with an offsetting cost. The farther off the reservation management goes, the greater the losses for investors before a run finally closes the bank.
Just think how much more value the SVB management team would have destroyed – with the connivance of the board and supervisors – if uninsured depositors had not pulled the plug on its inglorious reign by demanding their money. This is not to suggest that SVB’s uninsured depositors were an alert group of stakeholders. On the contrary, they had little idea of the risks that were building. But once they caught a whiff, the party was over.
Bank runs can also have a salutary effect if bank management, knowing the extreme penalty associated with excessive risk, manages prudently. Viewed in this light, the occasional depositor run is a feature of the system, not a bug to be eliminated by raising banks’ capital requirements. By effectively insuring all uninsured deposits after the March mini-crisis, the Fed and the US Department of the Treasury prevented a wider bank panic. But they also kept a lot of incompetent bank managers in place by turning uninsured depositors into passive onlookers – and, indeed, into capital.
While we do not want banks to be so thinly capitalised that small losses and accidents can precipitate panic and much larger losses, we also must recognise that, beyond a certain point, more capital can facilitate mismanagement. At the end of the day, higher requirements can make capital costlier, potentially inhibiting banks’ ability to finance growth – as Dimon warns. And if activity migrates to other institutions with lower capital requirements, the system will not have been made safer.
This risk is not merely hypothetical. A big problem facing US regulators today is that smaller banks picked up now-shaky commercial real estate lending that larger banks had avoided, owing to the latter group’s higher capital requirements. It remains to be seen how these smaller institutions will manage the coming loan losses.
Sensible regulation depends on knowing when a tool loses effectiveness and becomes counterproductive. More is not always better.
PUBLISHED ON
Nov 04,2023 [ VOL
24 , NO
1227]
Radar |
Viewpoints | Mar 12,2022
Commentaries | Sep 30,2023
Verbatim | Jun 26,2021
Fortune News | May 04,2019
Radar | Feb 24,2024
Fortune News | Nov 11,2023
Agenda | Oct 30,2021
Sunday with Eden | Jun 05,2021
Editorial | Jan 18,2020
My Opinion | 117180 Views | Aug 14,2021
My Opinion | 113205 Views | Aug 21,2021
My Opinion | 112092 Views | Sep 10,2021
My Opinion | 109922 Views | Aug 07,2021
Aug 18 , 2024 . By AKSAH ITALO
Although predictable Yonas Zerihun's job in the ride-hailing service is not immune to...
Jul 13 , 2024 . By AKSAH ITALO
Investors who rely on tractors, trucks, and field vehicles for commuting, transportin...
Jul 13 , 2024 . By MUNIR SHEMSU
The cracks in Ethiopia's higher education system were laid bare during a synthesis re...
Jul 13 , 2024 . By AKSAH ITALO
Construction authorities have unveiled a price adjustment implementation manual for s...
Nov 30 , 2024
In the corridors of government offices worldwide, the question of how much to pay mem...
Nov 23 , 2024
The fiscal puzzle deepens as the Council of Ministers approved a supplementary budget...
Nov 16 , 2024
In the realm of public finance, balance sheets speak louder than rhetoric. In such do...
Nov 9 , 2024
Ethiopia's foreign exchange debacle resembles a tangled web of contradictions and con...
Dec 1 , 2024
France and Ethiopia have reinforced their bilateral relationship with a landmark agreement signed on Saturday, November 30, 2024, increasing...
Dec 1 , 2024 . By BEZAWIT HULUAGER
Addis Abeba is taking a hard look at its fire safety protocols as the city's Fire & Disaster Risk Managem...
Dec 1 , 2024 . By BEZAWIT HULUAGER
Brook Taye (PhD), CEO of Ethiopian Investment Holdings (EIH), Ethiopia's sovereign wealth fund, has appoi...
Dec 1 , 2024 . By AKSAH ITALO
A bill proposing sweeping reforms to the urban land lease system was tabled in Parliament last month, int...