The cost of capital


People walk past a Capital One banking center in New York's financial district January 17, 2013.

Article Highlights

  • President Obama is right that we need to improve lending. Let’s hope his regulators take notice.

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  • Tighter lending is the unintentional but direct result of the Dodd-Frank Act.

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  • Regulators are requiring banks to hold unprecedented amounts of capital.

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Last week, President Obama called on banks to increase lending. Banks don’t need that call — the president’s regulators do. That’s because tighter lending is the unintentional but direct result of the Dodd-Frank Act and the Obama administration’s own priorities.

The narrative used by the administration — that credit seized up during the financial crisis and has been tight ever since — just isn’t true. When the recession officially ended in the middle of 2009, consumer credit at the largest 100 banks shot up, increasing from $880 billion to $1.2 trillion. One year later, the Dodd-Frank Act — which was designed to make the financial service system safer and stronger — was passed. Consumer credit at big banks has contracted ever since.

Some blame borrower pessimism about the economy, but there is strong reason to believe that Obama administration regulators are the driving factor.

Regulators are requiring banks to hold unprecedented amounts of capital — arguably over and above what is needed to protect the industry from another meltdown. To pass the Federal Reserve’s recent stress tests mandated by the Dodd-Frank Act, banks had to stay solvent against conditions worse than the last recession and maintain a significant capital buffer to boot. Banks were forbidden from paying out dividends unless they passed the test, and they must hold this vast amount of capital regardless of present or projected economic stress.

Fortifying banks to this extent is not free. Capital on banks’ books is like money under a mattress. It cannot be used for profit-oriented activity, like loans. Because banks can leverage loans, an old industry rule of thumb is that each additional dollar of capital restricts lending by $7 to $10.

That rule of thumb suggests the impact of tight regulations on lending is massive. Over the past five years, banks have increased Tier 1 capital — the core measure of safety from a regulator’s point of view — by nearly 30%, from $991 billion to $1.26 trillion, the highest in history. This increase in capital alone represents nearly $2 trillion in forgone loans or, presuming an average mortgage size of $200,000, about 10 million home mortgages.

To top it off, when banks do lend, regulators apply “capital punishment” through a process called risk weighting. Regulators assign risk weights to bank assets based on their perceived riskiness. The higher the risk weight, the more capital the bank has to hold against that asset. The joint notice of proposed rulemaking from the Federal Deposit Insurance Corporation, Federal Reserve, and Office of the Comptroller of the Currency on Basel III is a perfect example. Home mortgages are given a risk weight of up to 200%, meaning that banks must hold a lot of additional capital if they want to be in the mortgage lending business. Meanwhile, sovereign debt for E.U. countries is given a 0% “risk weight.” Yes, this includes Cyprus.

To be sure, capital is essential to safety and soundness. It buffers banks against unwelcome and unexpected future shocks. However, increasing capital requirements is also a surefire way to keep banks from lending, and that’s exactly what we are seeing today.

Indeed, banks are moving their portfolios away from loans at the same time bank capital is at a record high. As the result of the plethora of capital requirements from the Dodd-Frank Act, the cost of lending will increase by 360 basis points and real GDP will contract by 3.2% over the next five years, according to estimates from the Institute of International Finance. Even the Basel policymakers acknowledge their policies will dampen economic growth, estimating a 0.20% decline in GDP over the next four years from the Basel III capital policies alone.

While policymakers deserve some credit for erring on the side of caution, both marginal borrowers struggling to obtain loans and the broader economy deserve to know the very real costs of this obsession with capital requirements. Bear in mind: no institution that entered the financial crisis with more than 7% Tier 1 capital suffered any risk to solvency, according to a study by the Clearinghouse Association. Today, the biggest U.S. banks boast a 12.9% Tier 1 capital ratio. The Federal Reserve’s recent stress test confirmed our nation’s biggest banks would stay solvent and have capital to spare if we experienced another deep recession (all of the stress-tested banks except for Ally Financial maintained capital buffers over 5% in the “extremely adverse” scenario).

Regulators are manipulating levers that drive up costs and discourage lending, then wringing their hands when banks shy away from loans. All the while, there has been very little serious discussion about how financial regulatory reform impacts the economy. Hundreds of costly new rules and requirements cannot be imposed on banks without affecting the recovery. It’s time for a serious discussion about which requirements actually make us better off and which unnecessarily hold back lending and economic growth.

President Obama is right that we need to improve lending. Let’s hope his regulators take notice.

Abby McCloskey is the program director for economic policy studies at the American Enterprise Institute.

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About the Author


  • Abby M. McCloskey is the program director of economic policy at the American Enterprise Institute (AEI) where she disseminates the work of AEI’s economic policy team. McCloskey also studies and writes about various financial services policy issues.

    Immediately before joining AEI, McCloskey was director of research at the Financial Services Roundtable where she worked on financial regulatory reform, including Dodd-Frank and Basel III. McCloskey has also worked for US Senator Richard Shelby, and for the Mercatus Center as a Charles Koch Institute associate. While at Mercatus, she created and hosted a video series on financial markets issues.

    McCloskey has a B.A. in economics from Wheaton College.

    Follow McCloskey on Twitter: @abbyeconomics

  • Phone: 202.862.5819

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