Will increased capital prevent the next crisis?

Jun 20, 2011

Following on from the financial crisis in 2007-08, global regulators have been developing new capital requirements for banks in order to make them safer. The Basel III accord mandated a Tier 1 capital ratio of 7% - this represents the amount that banks need to set aside to cover potential losses from bad loans and investments.

The new proposals will impose additional capital requirement surcharges of up to 2.5% (on top of the 7%) on banks depending on their riskiness. The surcharge will depend on the bank’s size, their global presence, and complexity of their asset structure. Especially important will be how interconnected they are with the financial system - i.e. how much damage would be caused to the wider financial system and the economy if a particular bank got into trouble. Effectively, the surcharges would apply to banks and financial institutions that are too big to fail.

The surcharges are also there to discourage risky behavior. The more risky a bank is, the higher the surcharge, so banks should have an incentive to be safer. It is certainly the case that capital requirements were not high enough prior to the crisis, and this was one of the main reasons that banks were unable to protect themselves when they suffered losses on their loan books.

Thus, higher capital requirements are a step in the right direction. This is especially so if penalties are applied for more risky behavior. There is some downside to higher capital requirements. It will mean that banks have less money to lend and this could dampen economic activity. Additionally, the banks will become less profitable.

It therefore comes as no surprise that all the large banks are lobbying regulators to prevent stronger capital requirements from being implemented. Their biggest cause for concern is that it will reduce their profitability. This will especially occur when economies are booming and banks start to want to take more risk.

Increasing capital requirements on their own will not be enough to stop another banking crisis from occurring. There were numerous other factors that led to the crisis, so this is only a part of the solution. Nonetheless, higher capital requirements are still a good idea. They will make banks safer and reduce the risk of them getting into financial difficulty.

Banks have a special place in the economy. They are not like other companies. Banks are responsible for extending the credit that drives the entire economy, so the health of the banking system is critical to the rest of the economy. The biggest difference between the banking sector and other sectors is that the banking sector cannot be allowed to fail. If a bank goes bust it has dire consequences on everyone else. As a result, most governments will bail out their banks if they get into trouble, as they are too important to fail. This privilege must come at a price. This price is the right amount of regulation to ensure banks do not get into trouble in the first place. Banks should be servants of the economy, not the masters.

Disclosure: I do not hold the currency/commodity discussed in this article.