Are Capital Requirements Meaningless?

Yes, essentially.

The push for more strict capital requirements has become very popular among economists and policy pundits. To understand the calls for stricter capital requirements, consider a basic textbook analysis of a consolidated bank balance sheet. On the asset side, banks have things like loans, securities, reserves, etc. On the liability side a traditional commercial bank has deposits and something called equity capital. Given our example, equity capital is defined as the difference between the bank assets and deposits (note that banks don’t actually “hold” capital).

So why do we care about capital?

Suppose that assets were exactly equal to deposits. In this case the equity capital of bank would be non-existent. As a result, any loss on the asset side of the balance sheet of the bank would leave the bank with insufficient assets to cover outstanding liabilities. The bank would be insolvent.

Now suppose instead that bank’s assets exceed their deposits and the bank experiences the same loss. If this loss is less than the bank’s equity capital then the bank remains solvent and there is no loss to depositors.

The call for capital requirements is driven by examples like those above coupled with the institutional environment in which banks operate. For example, banks have limited liability. This means that shareholders are subjected only to losses to their initial investment in the event that a bank becomes insolvent. Put differently, bank shareholders are not assessed for the losses to depositors. Since the private cost of insolvency is less than the public cost, shareholders have an incentive to favor riskier assets than they would otherwise. Conceivably, this notion is well-understood since the the shift to limited liability for banks in the early 1930s was coupled with the creation of government deposit insurance. However, while deposit insurance insulates deposits from losses due to insolvency, it also has the effect of encouraging banks to take on more risk since depositors have little incentive to monitor the bank balance sheet.

Within this environment capital requirements are thought to reduce the risk of insolvency. By requiring that banks have equity capital greater than or equal to some percentage of their assets, this should make banks less likely to become insolvent. This is because, all else equal, a greater amount of capital means that a bank can withstand larger losses on the asset side of their balance sheet without becoming insolvent.

There is nothing logically wrong with the call for greater capital requirements. In fact, calls for greater capital requirements represent a seemingly simple and intuitive solution to the risk of financial instability. So why then does the title of this post ask if capital requirements are meaningless? The answer is that calls for higher capital requirements ignore some of the realities of how banks actually operate.

The first problem with capital requirements is that they impose a substantial information cost on bank regulators. How should value be reported? Should assets be marked-to-market or considered at book value? Some assets are opaque. More importantly, this practice shifts the responsibility of risk management from the bank to the regulator. This makes the actual regulation of banks difficult.

Second, and more importantly, is that capital requirements provide banks with an incentive to circumvent the intentions of the regulation while appearing compliant. In particular, a great deal of banking over the last couple of decades has been pushed off the bank balance sheet. Capital requirements provide banks with an incentive to move more assets off their balance sheet. Similarly, banks can always start doing bank-like things without actually being considered a bank thereby avoiding capital requirements altogether. In addition, this provides an opportunity for non-banks to enter the market to provide bank-like services. In other words, the effect of capital requirements is to make the official banking sector smaller without necessarily changing what we would consider banking activity. Put simply, capital requirements become less meaningful when there are substitutes for bank loans.

Advocates of capital requirements certainly have arguments against these criticisms. They would be perhaps correct to conclude that the costs and imperfections associated with the actual regulation would be work it if capital requirements brought greater stability to the system. However, the second point that I made above would seemingly render this point moot.

For example, advocates of higher capital requirements seem to think that redefining what we call a bank and adopt better general practices for accounting reporting would eliminate the second and most important problem that I highlighted above. I remain doubtful that such actions would have any meaningful impact. First, redefining what a bank is to ensure that banks and non-banks in the current sense remain on equal footing regarding capital requirements is at best a static solution. Over time, firms that would like to be non-banks will figure out how to avoid being considered a bank. Changing the definition of a bank only gives them the incentive to change the definition of their firm. In addition, I remain unconvinced that banks will be unable to circumvent changes to general accounting practices. Banks are already quite adept at circumventing accounting practices and hiding loans off of their balance sheets.

Those who advocate capital requirements are likely to find this criticism wanting. If so, I am happy to have that debate. In addition, I would like to point out that my skepticism about capital requirements should not be seen as advocacy of the status quo. In reality, I favor a different change to the banking system that would provide banks with better incentives. I have written about this alternative here and I will be writing another post on this topic soon.