THE WHOLE SUBJECT of international banking regulation, and in particular the topic of capital standards for large banks, may seem a bit untimely just now, what with Europe’s banks at the brink of collapse — even though regulators declared them amply capitalized just weeks ago. Given that recent history, it’s tempting to write off the debate over capital standards as not only eye-glazing but fundamentally irrelevant.
But manipulable and difficult to enforce as they may be, capital standards are one of the best regulatory tools for promoting financial stability, because holding substantial capital is one of the few things banks can do that actually helps them withstand panics. Regulators can, and should, design deposit insurance schemes and resolution mechanisms to deal with bank failures; a firm capital base, though, protects banks from failing in the first place.
Indeed, Europe’s current plight merely reinforces the point. And the job of devising better capital standards on a global scale falls to the international negotiation process known as “Basel III.” The latest Basel III agreement is due for submission to world leaders Thursday at the Group of 20 summit conference in Cannes, France.
The good news is that Basel III produced a consensus in favor of stronger capital requirements; by 2019, banks will have to hold at least 7 percent of their assets in common equity and retained earnings. Controversy still rages, however, about a proposal to make two dozen or so giant global banks, known as “systemically important financial institutions,” hold even more capital than that.
The idea is that this capital “surcharge” helps protect against the risk that the downfall of a huge and widely interconnected institution could bring the world financial system down with it. Not only that, but the surcharge will be adjusted (within a range) depending on how globally risky regulators judge a particular bank to be. This is a disincentive to bigness as such — one of the rule’s advantages, according to Federal Reserve Chairman Ben S. Bernanke.
Not surprisingly, bankers are pushing back, led by Jamie Dimon of JPMorgan Chase, who argues that the proposed surcharge is not only unnecessary but discriminatory against U.S. banks, in part because, as recent experience shows, European regulators are more lenient about capital than their U.S. counterparts.
The bankers have a point: There is an inherent tradeoff between tighter bank regulation and the availability of credit. Higher capital requirements function, economically, as a tax. To the extent banks must keep more of their resources in reserve, they are less able to lend to job-creating businesses, so they are probably right to point to various studies suggesting that higher capital standards would retard growth to some extent.
What’s harder to calculate, of course, are the risk of crisis that may go along with “too much” lending — and the value of preventing crises. But we know one big lesson of the financial crisis is that everything is riskier than it seems, or at least it might be.
Regulators are wise to err on the side of caution, and to add a capital surcharge to systemically important institutions. Yes, it’s hard to define such institutions precisely, as Mr. Dimon and others protest — but not impossible.
A tougher question is whether the surcharge should be a flat percentage applied to all systemically important institutions or whether, as proposed, regulators should graduate it according to more refined criteria. The regulators’ argument is that they do not want to create a sharp difference in policy toward two banks that present almost the same risk profile. But line-drawing problems come up no matter how you attempt to make distinctions.
As Basel III moves from the drawing board to full implementation by member countries, the authorities will have to show that it is truly adding safety and soundness, and not just more complexity.