Capital requirements have been the main tool of banking regulation since the 1990’s. International regulation has evolved quite a bit during the last 30 years or so. Many of the main issues are still unsolved however. The global banking crisis that began in the US in 2007 induced the G20 leaders to decide on more stringent capital requirements for banks. The new regulatory regime known as the Basel III, is supposed to make bank failures less common. More capital means less leverage. However, the banking lobby has been fierce in protecting the status quo, i.e. low capital requirements and high leverage. In this article I will try to elaborate a little on the basic arguments around these issues.
Why we need to regulate banks in the first place?
In general, public regulation can be justified theoretically because of market failures that can evolve from market power, externalities or asymmetric information between buyers and sellers. The classical Diamond -Dybvig framework  shows that when banks provide liquidity insurance, they actually create a bank run equilibirium. In general, bank runs have been quite frequent since the days of John Law and fractional reserve banking. Banks finance illiquid loans by transforming maturity via issuing demand deposit instruments (=create private money) and this creates easily a loss of confidence in the mind of the public sphere. The ability to create private money (deposits are used to settle day-to-day transactions) is one peculiar feature of banking business, see e.g. . This essentially means that banks’ creditors are their customers. The bulk of banks’ debt is held by uninformed small agents (households and small firms). Another distinctive feature is the paramount role of banks in the modern payment and settlement systems. Banks form a crucial part of modern society’s infrastructure.
Why then the bank managers do not choose the optimal amount of risk and capital in order to mitigate the possibility for bank runs? This is due to conflict of interest between the depositors and equity holders. See for example the article by Jensen and Meckling . Usually the agent representing the owners of the bank will prefer to choose more risky investments than the depositors would prefer. Therefore the depositors need to be protected. One can think of this also as a problem due to limited liability; the maximum loss for the equity investor is bounded, whereas the potential upside is in principle unlimited. If the agent has low risk aversion mentality, it makes sense to maximize the expected return of investments (=prefer relatively risky projects), see e.g. Dewatripont and Tirole . In general, executive pay schemes and managerial incentives matter of course and can have a substantial effect on bank risk taking behaviour. The post 2008 regulatory regimes tries to tackle these corporate governance issues as well.
Because of the frequent and inherent bank runs, public authorities have created institutions like deposit insurance and central banks, which are to prevent bank runs in the first place. Central banks can provide (artificially) cheap refinancing to illiquid but more or less solvent banks (originally due to Walter Bagehot), whereas deposit insurance is to convince bank customers (bank creditors) that their money is safe and guaranteed ultimately by the central government, i.e. the taxpayer. Moreover, governments have stepped in to bail out failing banks by e.g. injecting equity into the troubled institutions or buying stressed assets from the banks at face value. All this can be costly to the taxpayer and to the politicians. Bank runs and bank failures often involve cross-border contagion and as banks form the bone of the payment system, the whole system cannot be let to fail at the same time. Global financial system meltdown would be a total catastrophe.
There is therefore a strong case for bank regulation because of these reasons. In this post I will not consider radical alternatives to bank regulation like abolition of central banks, free banking, Chicago Plan or the like.
Capital requirements as a tool for regulating banks
The most important regulatory instrument currently is the minimum requirement of regulatory capital. If a bank has a total amount of risk (RWA), calculated as a risk weighted average of bank assets, the minimum amount of capital (CET1~shareholder’s equity + retained earnings) should be at least >4,5%*RWA. Banks tend to hold some more capital than the minimum requirements, as breaching the limit might lead to a bank resolution procedure or at least to a supervisory intervention, which would quickly cause trouble in the wholesale and interbank funding markets.
The amount of capital, in principle, will make bank failure less likely in a given time horizon as distance to default gets longer. Notice that minimum capital is there to absorb unexpected losses (some small/tail quantile of the loss distribution). Expected losses are in principle covered by loan margins and required asset returns. In terms of nominal values, banks hold typically nowadays some 4 % of equity as a percentage of the balance sheet total. This means that if the value of the bank assets go down more than 4 %, the equity is wiped out and the bank fails. This is not a large number, it is more like statistical volatility/noise in terms of loss variation. Basel III has raised the capital requirements, but only to a small extent. So why the level of leverage in banks is so large compared to other lets say non-financial listed companies?
Banks’ business model is about creating leverage
Banks’ core business is to make loans by issuing demand deposits. This is very useful and can be called also financial intermediation or maturity transformation, but the point is to collect net interest income from extending loans. Proper pricing of risk is of the essence. This of course then involves managing and evaluating credit risk, but from the point of this analysis, it is important to realise that the core business of banking implies naturally high leverage as demand deposits are liabilities of the bank. Before the financial crisis, the levels of equity could be as low as around 2 per cent of balance sheet total. We all have seen the consequences.
The implicit government guarantees, be it in the form of bail-outs, central bank refinancing or deposit insurance, makes high leverage possible. I do not think that any bank could have only 5 per cent equity without these public subsidies, especially important is the cheap central bank liquidity/emergency support. So high leverage is supported by the implicit government subsidies.
Why banks do not want higher capital requirements ?
Bank managers in general want to maximize the return on equity (ROE), as this supposedly reflects the future dividends for shareholders and therefore it tends to maximize the value of shares, which usually then maximizes the executive pay. As explained above, the interest of the shareholder might be also to take too much risk, because of limited liability. This would be appropriate in a world without public support mechanisms =free and fair market, and if the banks did not have such a paramount role in society in terms of payment systems and money/credit creation.
The bank lobby therefore usually tends to dislike capital regulation. This has to do at least with three things. First of all, other things being equal, higher capital level erodes the actual return on equity and it supposedly increases the weighted average cost of capital. The first claim is technically correct. However there is a difference between the actual return on equity and the required return on equity.
What is important is the required return on equity (RROE) by the equity investors. As additional risk must be compensated with additional return, it is clear that the shareholders must earn more compared to the depositors or the bond holders. However, the effect of lower leverage lowers the risk of bank failure (distance to default) at the same time and it therefore lowers the demanded risk premia of the debt holders and the equity holders. This offsets the increase of costs due to the increase in the equity/debt -ratio. So the required return on equity goes down while the cost of debt goes down as well.
Basically what I am arguing above is that the weighted average cost of capital (WACC) is independent of the debt-equity mix. This is of course all familiar from corporate finance 101, it is the famous Modigliani-Miller theorem, see e.g. . There is one important reason on top of the tax deductions of interest costs that might make the WACC to be somewhat dependent on debt-capital mix. It is that if the elasticity of risk premia of the debt investors and equity holders is close to zero due to the public support schemes. That is, if for example the creditors of the bank do not benefit from additional loss absorbing capital because they enjoy from full protection by some public scheme.
What would the shareholders want?
According to empirical studies, most of the people are risk-averse, including investors. Therefore the typical shareholder of a bank should care about risk-adjusted ROE and not just vanilla ROE. Risk adjusted ROE could be defined as RaROE=ROE/Risk. As for bank, we could measure the risk simply through the ratio Risk=RWA/CET1 so we would have RaROE=ROE*(CET1/RWA)=Return/RWA. So this simple argumentation shows that the banks’ management should focus on maximizing basically the Sharpe ratio instead of vanilla ROE. So we do have some principal-agent asymmetry here as well.
What about risk-adjusted capital regulation vs. leverage ratios ?
The current regulatory regime is technically too complicated. It is not as complex as the Einstein field equations above, but I think we would benefit from a simpler capital regime. Small banks at least could benefit from a more proportionate regulatory regime. There are at least a couple of problems with the current risk-adjusted regime.
The most important problem is the model risk. In the current envinronment the banks can basically determine their own regulatory risk, i.e. the total risk, RWA. This in turn entails possibly some regulatory capture and asymmetric information, because the big banks can afford to hire the best technical people to justify that their models are correct. Moreover, for example the current regime allows a zero risk weight for sovereign exposures. Model risks also involves uncertainty is terms of risk metrics and distributional assumptions. I guess the industry standard is normal distribution + VaR.
I would think we could abolish altogether the Basel regime for small banks and introduce mere leverage ratio requirement. Big banks could still use RWA, but the leverage ratio requirement should be a lot higher for large banks, perhaps around 10 per cent of total assets. One should also note that the shareholders should take care of the allocation problem with leverage ratio, i.e. even though a flat leverage ratio of say 10 per cent would incentivise bank managers to take on more risk, the maximizing behaviour of the shareholders shoud care about Return/RWA, so that the portfolio should be always optimal according to the preferences of the shareholders. I am just stressing this point because the lobbyist always argue that leverage ratio would distort banks towards excessive risk. I do not think this is the case, because the shareholders care about risk-adjusted returns, or banks’ RaROE.
Do higher capital requirements hurt the economy?
One of the usual arguments against capital requirements is that they hurt the economy. The lobbyist would either argue that higher capital requirements would lead to higher margins, or that lending would be severely constrained. The first argument of the lobbyists is not valid as in any competitive market there should be no reason why the banks would not raise the margins even without any higher capital requirements, if the loan customers are willing to pay for it. Moreover, if there is competition, lower margins would attract customers, not repel them. Second, a large chunk of new bank lending goes into financing real estate and not to non-financial companies financing investment and therefore the price level in the housing market would suffer if anything. Finally, higher capital requirements can be naturally satisfied by retaining a larger portion of earnings. So less dividends and less share buybacks. Empirical data does not find any support for the lobbyists argumentation either. We have seen high growth rates with low bank leverage. Of course lower ROE would be bad in terms of comparison across sectors. Banks typically enjoy superior ROE compared to Main Street
Of course any monetary economy is dependent on bank lending, as bank lending creates purchasing power and purchasing power creates aggregate demand and therefore investment and employment, but my argument is that we could find a new and better general equilibrium via higher levels of bank capital.
My central thesis here (again) is that modern finance is always inherently fragile and prone to endogenous crises. The root reason is centered around the banking system. Banking system creates an artificial asymmetry in the economy by issuing safe, liquid and short term liabilities to fund risky, illiquid and long term assets. This asymmetry in the balance sheet means almost tautologically that the equity must be economically really risky, at least for the taxpayers. This means that there should be less leverage and more capital, at least until we have a system where junior and senior debt can really absorb losses substantially.
Recent developments like introducing the TLAC and other resolution instruments are all very well, but to me it seems that given the recent experiences in Europe, bail-in can be very difficult to implement in practical and political terms and therefore I think what we need is good old equity.
Moreover, the lobbyists argumentation is not supported by data and the ROE-fallacy is based on uneconomical thinking.
PS: The NPL-problem in Europe could be solved by writing off the non-performing assets and recapitalising the banking sector. This is yet another piece of evidence that there is too little capital in the banking system.
 Diamond, D. W., and P. Dybvig. 1983. Bank runs, deposit insurance, and liquidity. Journal of Political Economy 91 (3): 401-419
 Jacab, Z. and M. Kumhof in Bank of England Working Paper No. 529: Banks are not intermediaries of loanable funds – and why this matters http://www.bankofengland.co.uk/research/Pages/workingpapers/2015/wp529.aspx
 Jensen, M., and W. R. Meckling. 1976. Theory of the firm, managerial behaviour, agency costs and ownership structure. Journal of Financial Economics 3: 305-360.
 Dewatripont, M., and J. Tirole. 1993. Efficient governance structure: Implications for banking regulation. In Capital markets and financial intermediation, ed C. Mayer and X. Vives. Cambridge: CUP.
 Copeland, T. E., J. Weston. 1988. Financial Theory and Corporate Policy, 3rd edition, Prentice Hall, New Jersey 2003.