Opinion | Banking reform and increased capital funding needed now


Stephen Cecchetti is Professor of International Finance at Brandeis International Business School. Kim Schoenholz is a clinical professor emeritus at New York University’s Stern School of Business.

Less than a year ago, local bank runs led to the collapse of First Republic, Silicon Valley Bank, and Signature Bank, the second, third, and fourth largest banks in U.S. history. But powerful banking lobbies are once again actively resisting reforms that would make the financial system safer and more efficient.

This time, U.S. officials must push back and pass modest reforms without compromise.

The main debate revolves around regulators’ calls for higher capital requirements, meaning a greater proportion of banks’ funds come from shareholders (equity) rather than from depositors and bondholders (borrowing). It is. Banking advocates argue that because this capital is somehow sitting idle, increasing capital requirements waste resources, constrain lending, and reduce the ability of households and businesses to finance essential activities. claim.

The truth is that capital I never have wasted resources. This is the source of funds that banks use when making loans. Well-capitalized banks have more rather than fewer resources to provide credit.

Banks (accurately) view equity capital as an expensive source of funds, and the owners who provide it demand higher returns than the interest rate banks pay to depositors. They finance their activities much less with equity (or retained earnings) and prefer to borrow more through deposits and bond issues. In other words, banks are looking for more leverage.

However, banks’ preference to lend themselves largely reflects distortions created by public policy. First, interest payments reduce banks’ taxes, but payments to investors offering shares (dividends) do not. Second, shareholders of banks with low capital enjoy large profits when the bank makes a profit, while creditors (including ultimately taxpayers) risk bankruptcy when the bank makes a loss. I will bear it. Third, for large banks, which are considered too big to fail, the existence of implicit government guarantees further reduces borrowing costs. As a result of these distortions, shareholders and bank managers developed a strong preference for borrowing.

From the national point of view, none of these distortions make sense.Therefore socializing The cost of more bank capital is private It costs money. In fact, by countering the factors that distort banks’ preferences, they can raise more capital funding. reduce social cost.

How does increasing bank capital requirements make the financial system safer? By creating a buffer against bank failures if adverse events reduce the value of bank assets. Large capital buffers reduce the incentive for uninsured depositors to flee, as they did when rising interest rates drove down the value of assets at First Republic, Silicon Valley Bank and Signature Bank.

Higher capital requirements for banks also increase the efficiency of the financial system. Banks have more “skin in the game” and therefore have greater incentive to scrutinize the use of funds. As a result, they are less likely to lend to unprofitable, highly indebted businesses (also known as zombies) that cannot survive unless someone provides more credit.

Indeed, some details of the current proposal, known as Basel III Endgame, may be worth revisiting. For example, calculations of operational risk capital (the owner’s net worth that provides a buffer in case of errors, theft, technical failures, etc.) should reflect the lack of correlation between risks. However, these issues are minor compared to the broader objectives of the reform.

Importantly, regulators’ proposals to increase capital requirements would directly impact fewer than 40 of the more than 4,500 U.S. banks. Although these targeted banks account for the bulk of the activity, this reform will limit the cost and complexity of the remaining banks.

That said, the proposal would apply higher requirements to large local banks, such as the one that recklessly failed last year. This is important. The lasting lesson of the 2023 episode is that banks that receive generous regulatory action in times of crisis require higher levels of regulation. self insurance. Banks that know that the authorities will bail them out have greater incentives to take risks now and are more likely to experience future crises. The solution is to make banks, whose failures put the financial system at risk, directly shoulder the broader risks they pose.

Experience in increasing U.S. capital requirements is a huge advantage. In the years following the 2007-2009 financial crisis, policymakers significantly increased capital requirements. What followed was the longest economic cycle in U.S. history, fueled by an increase in bank lending. U.S. banks continue to outperform their foreign counterparts, even though critics argue that domestic regulations will be stricter than those abroad. Simply put, well-capitalized banks provide a durable competitive advantage because depositors, investors, and borrowers prefer healthy banks.

One of the common objections to raising bank capital requirements is that it shifts some risky lending and trading activities to non-banks such as brokers, mutual funds, and insurance companies, without making the financial system safer. That’s what I’m going to do. However, not all of these activities are best funded by bank deposits, which are prone to runs and panics, so some of these changes will make the overall system safer. Additionally, U.S. regulators should aim to treat risks borne by banks and nonbanks alike. For example, minimum down payment requirements can be imposed on government-backed mortgages regardless of the lender.Definitely condoning banks’ dangerous behavior do not have How to deal with the possibility of risk being transferred elsewhere.

U.S. banking regulators and their Congressional supervisors should resist the appeals of the banking lobbies. Ensuring a stable and efficient financial system starts with safe and sound banks. This means a high level of capital funding.



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