The Federal Reserve Board moved recently to ease monetary policy in response to the clear evidence of the declining pace of economic activity in the United States. By purchasing government bonds from the commercial banks and by eliminating the reserve requirements for certain types of deposits, the Fed is trying to encourage banks to increase their lending to customers.
We agree with the majority of economists who believe that the Federal Reserve's current expansionary policies will probably succeed in preventing a deep and prolonged recession. But while the most likely forecast is for a short and shallow period of negative growth, considerable uncertainty remains because it may now be more difficult than usual for standard Federal Reserve policy to be effective.
The Fed's ability to turn the economy around may be weakened by the new international agreement that banks must increase their capital as they raise their total lending. If a bank doesn't have enough capital, the new rules say that it cannot increase its total lending.
A bank's capital is the difference between the value of its loans, securities and other investments and the value of depositors' claims on the bank. Equivalently, a bank's capital is measured by the combined value of its shareholders' equity and the credit provided by holders of bonds issued by the bank.
Although the Federal Deposit Insurance Corporation is the ultimate safety net for most depositors, bank capital is rightly an important concern of bank regulators and uninsured depositors. A bank's capital is a measure of its ability to meet its obligations to its depositors. If bank loans go sour, the bank with enough capital will be able to meet its obligations to depositors without turning to the FDIC. Thus bank capital is a crucial cushion to protect the FDIC and the uninsured depositors against a decline in the value of the bank's loans and investments.
Recognizing the importance of this protection, the United States and other major industrial countries agreed to set uniform capital requirements. This so-called Basel Agreement calls for each bank to have in place by 1992 capital equal to 8 percent of its loans and other investments.
Most U.S. banks have already reached that goal well ahead of the 1992 deadline. But many banks have done so with very little extra capital to spare. In the present uncertain economic environment, few banks can raise additional capital by selling new stocks or bonds. And although bank capital will grow through retained earnings, that process is very slow.
All of this is potentially very important because banks with a tightly limited amount of capital won't be able to increase their lending even if the Fed pursues an easy-money policy by cutting the discount rate or reducing reserve requirements. Indeed many banks have been forced to shrink their lending in order to maintain their relative capital at the level required by the international agreements. And the problem may grow worse if future loan defaults reduce the banks' net capital or regulators require writing down the value of assets in anticipation of possible future losses.
Ironically, despite the constraining effect of bank capital requirements on the expansion of bank lending and economic activity, there is a tendency for the banks themselves to accumulate more than the minimum level of capital. This is encouraged by bank regulators, who being naturally cautious, often push banks to accumulate more capital than they are legally required to have. Banks themselves often want to have excess capital to protect themselves both against potential losses and against the possibility of additional requirements imposed by the regulators.
The ability of the Fed to encourage additional bank lending will depend on how close the banks are to their required capital ratio. If all banks had only enough capital to meet the requirements, no additional lending would be possible at all. Since there is in fact excess capital in some banks, the Fed can cause total lending to rise even though not all banks will be able to lend more.
The impact of the bank capital requirements can reduce the effectiveness of monetary policy in two ways. First, even if total lending increases, some small and medium-sized firms that are potential borrowers will be left out because they depend on a single bank that has no spare lending capacity. These smaller borrowers cannot have direct access to the capital market and are not well enough known to get credit elsewhere. Second, the uneven availability of new credit is likely to mean that the increased credit will have a smaller overall impact on total spending in the economy.
Paradoxically the very regulations that were set up to strengthen the international banking system may be weakening the Fed's ability to stabilize the U.S. economy. As a minimum, the Fed must recognize that it may take a lot more liquidity than usual to bring about the desired recovery in the months ahead.
Martin Feldstein was chairman of the Council of Economic Advisers from 1982 to 1984. Kathleen Feldstein is an economist.