Capital Punishment

Why stricter capital requirements wouldn’t have prevented our most recent financial crises.

Lehman Brothers former CEO Richard Fuld

Pretty much everyone —everyone, that is, except bankers and a handful of their supporters—agrees that there’s one surefire way to make the global financial system safer: Require banks to increase capital reserves. But there’s a risk in seeing stricter capital requirements as a catchall solution. Think about the past (the financial meltdown in 2008) and the present (the fear that a default by Greece will ignite another financial crisis). If banks had held more capital, would we have avoided either mess? I’m afraid the answer is no.

On June 25, global banking regulators will meet in Basel, Switzerland to hammer out international capital standards. The talk is that they will require banks hold 7 percent of risk-weighted assets in capital. (Risk-weighting means that assets that are supposed to be safer have a lower capital requirement, while those that are supposed to be riskier require more capital to back them.) The regulators will also likely tack on additional capital requirements for the financial institutions that are seen as being too big to fail. A few weeks ago, Federal Reserve governor Daniel Tarullo set off panic among bankers when he proposed that these behemoths should hold as much as 14 percent of their assets in capital.

A curious paradox of capitalism is its aversion to capital. When you think about it, capital is money (classically in the form of common stock) that isn’t owed to anyone, so it can protect those who are owed money, like bondholders, by absorbing losses first. It’s expensive, because the providers of capital want to be paid for putting their necks on the line. Bankers, whom we think of as the ultimate capitalists, can’t stand the stuff. Indeed, the new capital standards being contemplated in Basel have bankers up in arms. At a House Financial Services Committee meeting last week, industry representatives argued, among other things, that large capital requirements will raise the cost of the loans they make. Prominent economists, including Simon Johnson, former chief economist of the International Monetary Fund, and Anat R. Admati of Stanford, say this is bunk.

Regardless of who’s right about that, what seems to get lost in the public debate is what capital isn’t. It isn’t a literal pile of cash or stock certificates, but rather an accounting construct based on the difference between what the bank says its assets are worth, and what its liabilities are. If the bankers are wrong about how much their assets (i.e., their loans), are worth, then they’re wrong about how much capital they have. Capital is not the same thing as liquidity, with which it’s often confused. Liquidity is the ability to pay your current debts. It is possible for a bank to be solvent—i.e., have plenty of capital—but still fail because it doesn’t have the money to pay the people who want their cash today. The risk of this gets bigger when a bank, which has assets that pay over a long time, funds itself with short-term paper.

Historically, most, if not all, bank failures have resulted from a run on the bank, meaning that short-term lenders or depositors yank their money because they doubt the value of the bank’s assets. Once that fear sets in, it doesn’t matter whether the bank is well-capitalized or not: It runs out of cash anyway. Bear Stearns and Lehman Brothers could plausibly argue, at the time of their demise, that they were well capitalized, but they still suffered a run because investors no longer trusted the value of the assets. The very situation in which a bank most needs a lot of capital is when investors start to suspect that the bank might be lying about the value of its assets. At that point, no amount of capital is enough.

Look at lender CIT, which also failed in the crisis. In an effort to keep it afloat, the government injected $2.3 billion of capital. But CIT went bankrupt anyway, because despite the capital injection, it still couldn’t fund itself. The distressed creditors who then swooped in made a fortune—upward of $5 billion, one source tells me—because CIT, which quickly emerged from bankruptcy, had plenty of value. The problem wasn’t a lack of capital, and the problem didn’t get fixed by adding more capital.

More broadly, think about how the crisis was finally averted. The common perception is that the Troubled Asset Relief Fund, or TARP, which put billions of dollars of capital into the biggest banks, did the trick. But that’s not quite right. TARP showed that the government wasn’t going to let the banks fail, and it was that demonstration which averted the crisis of confidence. What really made a difference was the other things the government did, most notably the FDIC’s blanket guarantee of all the banking sector’s debts.

Today, the worst-case scenario is that a Greek default will ricochet through the system in much the same way that the collapse of Lehman Brothers did. It’ll increase the pressure on other debt-burdened countries, like Ireland, Portugal, and Spain. That in turn will affect European banks that own those countries’ debt. (Already, Moody’s has put three French banks on review for downgrade because of their exposure to Greece.) One way the panic could spread to the United States is through our $2.7 trillion money-market industry, which has a hefty percentage of its assets—44.3 percent, according to the latest study by Fitch Ratings—in European bank debt. If this debt is at risk for a downgrade, then the money market funds will have to start selling, because they’re only allowed to hold highly rated debt.

Greece’s problem (and Ireland’s, and Portugal’s, and Spain’s) is that it has too much debt. But if this worst-case scenario plays out, the European banks’ main problem will be that three years after the 2008 meltdown they’re still relying on an unstable source of funding. (The Investment Company Institute, which is the trade association for the mutual fund industry, says everything is under control. Market participants aren’t so sure, which is why one source of mine says about the capital debates, “The technocrats are fiddling while Rome burns.”)

Not only would higher capital requirements have failed to prevent these crises; conceivably they might have made them worse. The risk weighting that the regulators apply to assets encourages banks to hold more of the assets that are supposed to be low-risk. That’s why banks all owned a lot of mortgage-backed securities—they were purportedly low-risk, and banks didn’t have to hold much capital against them. Sovereign debt like Greece’s was also purportedly low-risk; that why banks owned a lot of it. Subsequent events showed that the risk weightings left something to be desired. Because they were standardized, they incentivized banks engaged in the same risky behavior. If you believe that crises come about because too many banks do too many of the same dumb things, then faulty international capital requirements are arguably worse than no such requirements at all.

If banks had more capital, wouldn’t they take less risk, because the bankers would have more to lose? I’m not sure the answer is yes, because the capital is still other people’s money. A better argument in favor of stricter capital requirements is that if there were more capital and less debt in the system, then the likelihood would diminish that short-term lenders and depositors would get scared enough to create a run. But in the gigantic, murky, interconnected world of global finance, I’m not sure there’s any amount of capital—any amount that still allows the system to function, that is—that would provide enough comfort under all circumstances.

In an ideal world, we would do a lot more than require banks to hold more capital. We’d mandate transparency in the valuation of their assets, so that outsiders had a prayer of knowing what the stuff on banks balance sheets was actually worth. We’d force banks not to rely on short-term funding, so they couldn’t have a liquidity crisis. And we’d make sure that regulators understood all the unique risks in each institution that they were regulating.

But none of that is going to happen. So maybe requiring more capital is the best we can do. But we should be aware that it’s an imperfect solution, and that getting the details wrong risks creating catastrophic problems down the road.