THE NEWS in financial affairs centers on two seemingly unrelated phenomena. First, markets went into a bit of a tailspin over speculation that the Federal Reserve was about to curtail its stimulative monetary policy; Fed officials had to issue reassuring statements to calm everyone down. Second, federal financial regulators proposed stiff new capital requirements that would probably force some of the nation’s top banks to shrink.
Actually, though, these events are connected: Some day, once the U.S. economy has returned to self-sustaining growth, the Federal Reserve will have to unwind its massive balance sheet. Interest rates will go up. Markets will react. And financial institutions could come under stress. One way to protect the wider economy against that potential instability is to make sure big banks are abundantly capitalized.
Indeed, even if the Fed’s “exit strategy” goes off without a hitch, a key lesson of the financial crisis is that “systemically important” financial institutions need larger, more transparent capital requirements — lest policymakers face a no-win choice between market meltdown and taxpayer bailout. Prior to the crash, institutions such as Lehman Brothers and Bear Stearns had liability-to-asset ratios of greater than 30 to 1. Banks generally were given wide latitude to value their own assets, a practice known as “risk-weighting.”
The proposed rule announced Tuesday by the Fed, the Federal Deposit Insurance Corp. and the Office of the Comptroller of the Currency requires the eight largest U.S.-based bank holding companies to keep the ratio between liabilities and assets at 20 to 1; for their FDIC-insured commercial bank subsidiaries, the ratio would be closer to 17 to 1. The standard is tough and clear. Though the precise definition of capital remains to be established, it is going to favor plain old shareholder equity and curtail risk-weighting.
This is not without costs. Only two of the eight affected companies, Wells Fargo and Bank of America, already meet the standards, and the FDIC estimates that the others will need an additional $89 billion to comply by the 2018 deadline.
As the banks argue, that $89 billion would no longer be available to lend to home buyers and job-creating businesses. Big banks’ reliance on debt financing, rather than equity, reflects not only the too-big-to-fail expectation of a government bailout, which gave them cheap access to funding. It also reflects the favored treatment of interest payments under the U.S. tax code. Requiring more equity increases their tax burden, which could be passed on to customers.
But the banks have other options for raising the money, such as reducing dividends and selling assets. Also evaluate the banks’ critique in light of this fact: Tougher capital requirements trim return on equity, upon which executive pay is based.
In short, the regulators’ proposal forces the nation’s largest financial institutions, whose combined assets exceed $11 trillion, to behave more conservatively, even at the cost of a marginal reduction in short-term economic activity. In return, the financial system will be more stable in the long run and less at risk of a massive bailout. It’s a trade-off; recent history suggests it’s one worth making.