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The public policy blog of the American Enterprise Institute
Wall Street is kvetching up a storm over modest toughening of megabank capital requirements by federal regulators. “This rule puts American financial institutions at a clear disadvantage against overseas competitors,” Tim Pawlenty, chief executive of The Financial Services Roundtable and former GOP presidential candidate, told Reuters.
The new rule increases the required leverage ratio — the amount of equity capital a bank holds as a share of assets — to 5% versus the 3% ratio in the international Basel III agreement. Under the new rule, megabanks could borrow only 95% of money they lend versus 97% under Basel. By 2018, they would have to rely more on selling stock or retained earnings.
If other nations want riskier big banks, that’s the business of their taxpayers who’ll be on the hook for future bailouts. A tougher leverage ratio and bigger safety cushion make the US financial system somewhat safer, but not as safe as it could and should be. The US has suffered 14 major banking crises over the past two centuries, as documented by Charles Calomiris and Stephen Haber in their new book, “Fragile by Design: The Political Origins of Banking Crises and Scarce Credit.” (None in Canada, by the way.) One could reasonably assume US economic growth would have been a least a smidge better without all those other crises.
In a recent Wall Street Journal op-ed, Calomiris and coauthor Allan Meltzer note that at the start of the Great Depression, the big New York City banks “all maintained more than 15% of their assets in equity” and none went bust. Likewise, “losses suffered by major banks in the recent crisis would not have wiped out their equity if it had been equal to 15% of their assets.”
Wouldn’t a 15% leverage ratio hurt bank lending and economic growth? Consider: First you have to calculate whether it would hurt economic growth more than a continuation of America’s serial financial crises. Second, it’s a pernicious myth that debt is somehow “more expensive” than equity capital. The more stock a bank issues, the less risky the bank becomes, and the lower the return shareholders demand.
Don’t banks know this? Look, banks are responding to incentives. Bank debt operates on unequal footing thanks to Washington’s “too big to fail” backstop. University of Chicago economist John Cochrane explains that without government guarantees, “a bank with 3% capital would have to offer very high interest rates—rates that would make equity look cheap.” Like researchers Anat Admati and Martin Hellwig in their book “The Bankers’ New Clothes,” Cochrane endorses dramatically higher capital levels. So should policymakers if they want to avoid another century of financial shocks.
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