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Despite Basel III, Higher Bank Capital Is No Silver Bullet

By John R. Dearie

Today the House Financial Services Committee is holding a hearing on the economic impact of new international bank capital rules, known as Basel III. Today's hearing comes as capital has emerged as a singular focus for many policymakers hoping to enhance the safety and soundness of the nation's banks and avoid a repeat of the 2008 crisis.

A bank's capital is the simple difference between the value of its assets and the value of its liabilities — the bank's net worth. Typically comprised of investor equity, retained earnings, and various types of debt obligations, capital serves the important economic purpose of providing a buffer or cushion against which unexpected losses can be absorbed without jeopardizing the bank's viability.

A heightened focus on capital is entirely appropriate. Sufficient loss-absorbing capital is a critical aspect of any bank's health and stability. And it is certainly true that many banks held too little capital before the recent financial crisis.

But it is also true that higher capital is not a silver bullet solution to the challenge of ensuring financial stability. In fact, unnecessarily high levels of capital can become problematic and even counterproductive.

Banks Are Healthy Again

Since the financial crisis, the capital position of U.S. banks has dramatically improved. In March, the Federal Reserve announced the results of the latest Comprehensive Capital Analysis and Review, better known as the "stress-test," which subjected the 19 largest banks to a severe crisis scenario.

The stress-test showed that since 2009 banks have nearly doubled their levels of Tier 1 common equity capital — the highest loss-absorbing form of capital. Overall, banking industry capital is at or near record levels.[1] Moreover, under the terms of the Basel III framework, the eight largest U.S. banks will be required to hold a surcharge of equity capital of between 1 and 2.5 percent of risk-weighted assets by 2019.

Commenting on the stress-test, Fed Chairman Ben Bernanke stated: "Under this highly adverse scenario ... 15 of the 19 bank holding companies were projected to maintain capital ratios above all four of the regulatory minimum levels."

Strength Across the Board

This dramatic improvement in capitalization has been achieved even as banks have made other improvements that have significantly reduced their overall risk.

For example, liquidity has dramatically improved, with large banks more than doubling their holdings of cash and liquid securities.

Leverage has been reduced, in some cases cut in half.

Asset quality is far stronger, with problem loans declining for nine consecutive quarters to their lowest levels since early 2008.[2]

Risk management, internal controls, and governance procedures have been significantly enhanced.

And compensation structures at most banks have been reformed to closely align the personal incentives of bank employees with the long-term performance and safety and soundness of the employing institution.

Misguided Reforms

This progress notwithstanding, some members of Congress and other observers contend that banks should hold much more capital. Since capital protects banks from losses, the thinking goes, more and more capital will make banks safer and safer, and bank failures — and potential bailouts — less likely.

Such calls for ever-higher capital overlook the fact that additional capital is not without costs or consequences, and can become counterproductive or even dangerous.

For example, too much capital can obstruct banks' ability to perform their critical role in the economy by limiting their lending capacity. An underperforming economy due to scarce credit ultimately undermines banks' safety and soundness by impairing asset quality and earnings.

An overreliance on capital can also distract policymakers from other equally relevant aspects of safety and soundness, such as the nature and strength of a bank's assets, the rigor of its risk management framework, the soundness of its internal controls and governance procedures, the quality and diversity of its earnings, and the reliability of its liquidity position. Considered in isolation, outside the context of these other essential aspects of safety and soundness, a particular capital level has limited meaning or supervisory value.

Excessive capital can also become perverse — potentially incentivizing greater risk-taking by banks. Higher and higher levels of capital erode banks' return on equity (ROE), a key measure of profitability. As ROE declines, banks' ability to attract the additional capital that regulators are requiring becomes more and more difficult. At some point, generating the returns necessary to attract additional capital from investors may require taking greater risk.

Capital is a critically important aspect of banks' safety and soundness. But as is the case in other contexts, sometimes there can be too much of a good thing. Rather than indulging in capital overkill to the detriment of economic growth and job creation, let's build on the progress achieved to date by allowing banks to do what they're intended to do — propel economic growth and job creation by supplying the credit that American businesses, homeowners, and consumers need.

John R. Dearie, Executive Vice President at the Financial Services Forum, is a former officer of the Federal Reserve Bank of New York. The views expressed are his own.

[1] FDIC, Quarterly Banking Profile, First Quarter 2012

[2] FDIC, Quarterly Banking Report, Second Quarter 2012