If average bank capital in 2008 had been, say, 20 or even 30 per cent of assets (instead of the recent levels of 10 to 11 per cent), serial debt default contagion would arguably never have been triggered. Had Bear Stearns and Lehman Brothers continued as capital-conscious partnerships, a paradigm under which both thrived, they would probably still be in business. The objection to a capital requirement of 20 per cent or more, even when phased in over a series of years, is that it will suppress bank earnings and lending. History, however, suggests otherwise.20 to 30 percent used to be the sort of thing one could not say in public without being branded some sort of nut.
Alan also echoes the main point. Banks need lots of regulators micromanaging their investment decisions, because taxpayers pick up the bag for their too-high debts. Banks with lots of capital do not need asset micro-regulation:
...An important collateral pay-off for higher equity in the years ahead could be a significant reduction in bank supervision and regulation.A double bravo.
Lawmakers and regulators, given elevated capital buffers, need to be far less concerned about the quality of the banks’ loan and securities portfolios since any losses would be absorbed by shareholders, not taxpayers. This would enable the Dodd-Frank Act on financial regulation of 2010 to be shelved, ending its potential to distort the markets — a potential seen in the recent decline in market liquidity and flexibility.
However, to be honest, I have to nitpick a bit on what seems like the right answer for some of the wrong reasons.
Alan seems to argue that the rate of return to equity is independent of leverage:
Banks compete for equity capital against all other businesses....
In the wake of banking crises over the decades, rates of return on bank equity dipped but soon returned to their narrow range. ...
What makes the stability of banks’ rate of return since 1870 especially striking is the fact that the ratio of equity capital to assets was undergoing a significant contraction followed by a modest recovery. Bank equity as a percentage of assets, for example, declined from 36 per cent in 1870 to 7 per cent in 1950..Since then, the ratio has drifted up to today’s 11 per cent.
So if history is any guide, a gradual rise in regulatory capital requirements as a percentage of assets (in the context of a continued stable rate of return on equity capital) will not suppress phased-in earnings..There is an exam question in here: what seems wrong? Answer: Competition for equity capital should drive the risk adjusted rate of return for bank equity to be the same as for other businesses. If banks issue more capital, the raw rate of return to equity should decline. So should the variability (beta, risk) of that return. (Other things held constant, which may well be why the historical record is muddy.)
In fact, Alan seems precisely to be making the banks' argument. They claim that the return on equity capital is independent of leverage. They have to pay (say) 10% to shareholders, but only 1% to debt holders, so debt is a cheaper source of financing. Banks claim that forcing them to issue more expensive capital will force them to raise loan rates and strangle lending. Which, curiously, Alan seems to be endorsing. Though he starts with
The objection to a capital requirement of 20 per cent or more, even when phased in over a series of years, is that it will suppress bank earnings and lending. History, however, suggests otherwise.He follows up with
...bank net income as a percentage of assets will be competitively pressed higher, as it has been in the past, just enough to offset the costs of higher equity requirements. Loan-to-deposit interest rate spreads will widen and/or non-interest earnings will increase.Ok, so earnings may not be affected, but a rise in loan-to-deposit spreads is exactly what the banks are warning of, and it's hard to see how that would not "suppress bank lending."
All this only happens if investors demand the same return to equity no matter what leverage, and competition then forces banks to deliver that return. This proposition is precisely what advocates (such as myself) or more capital deny. Investors are not that dumb, they demand a competitive risk adjusted rate of return. More capitalized banks will deliver lower rates of return -- and equally lower risk. Bank "stock" will look very much like long term bonds and become the cornerstone of safe portfolios. So we get all of Greenspan's benefits and none of the downside.
Of course, this is just an editorial. He may have meant "risk adjusted" return, and was trying to simplify language.