The Arithmetic of Capital Requirements

The news this week is that the Federal Reserve, the Office of the Comptroller of the Currency, and the Federal Deposit Insurance Corporation have announced their intention to raise -- in some cases double -- the capital requirements for large bank holding companies and some of their subsidiaries.

The politically correct line on this move is that it disciplines those responsible for our economic woes and represents real change. Accordingly, any expression of even modest concern over the move -- especially from the big banks -- is seen as selfish, or irresponsible, or an ideological reflex from those in the thrall of large-scale commerce.

For a second, put aside anything but the arithmetic. Let's suppose that I run a simple bank that has made $100 million in loans, financed by borrowing $97 million and raising $3 million of equity capital. Notice that this bank has a leverage ratio of 3 percent -- $3 of equity for every $100 of assets. Assume that borrowed funds cost 9.5 percent, while the loan portfolio yields 10 percent. As a result, the bank has gross earnings of $10 million (10 percent of $100 million) and costs of raising funds of about $9.2 million (9.5 percent of $97 million). The bank's net earnings of just under $800,000 are about 26 cents for every dollar of equity capital -- an equity rate of return of 26 percent.

Now, in the spirit of the recent announcement, suppose that the bank must meet a leverage ratio of 6 percent. To support the same $100 million loan portfolio, the bank must have $94 million in borrowed funds and $6 million in equity capital. Doing the same arithmetic, the rate of return on equity capital falls to 18 percent.

Notice that the bank is safer. It can absorb an additional $3 million in loan losses before reaching insolvency. This is the benefit side of the policy calculus.

But notice as well that the decline in the rate of return is the economic equivalent of imposing a tax on equity returns at a rate of 32 percent (32 percent of 26 percent is 8 percent in tax, leaving 18 percent after tax). If the federal government chooses to levy a new 32 percent tax on anything, would it be fair to characterize it as costless? Of course not.

Those costs come in two forms. The equity holders -- public-employee pension funds, 401(k)s, college endowments, and other ordinary American investors -- would see reduced returns. For the economy as a whole, new capital standards would impose a cost that shows up in the form of reduced lending, slower growth, and diminished incomes.

These costs are real and legitimate concerns that will arise from the new capital regime. Only an ideologue would oppose weighing these costs against the safety benefits of the new policy.

The tax analogy provides two other insights. Suppose that instead of capital standards, the government imposed the 32 percent equity tax and put its receipts in a fund used to stabilize banks when they get in trouble. If that came to pass, federal monies would be used to "bail out" my "too big to fail" bank, something that is highly unpopular policy. But higher capital standards are an economically equivalent policy: The accumulation of funds is simply disguised by putting a mandate on the private sector.

Now, consider the incentive effects of the de facto tax. My bank is now earning a lower rate of return, and my equity investors will want to withdraw and pursue opportunities to make the market rate of return. (Remember, this new policy isn't applied across the board, just to large bank holding companies and some subsidiaries, so the unaffected actors will be at a competitive advantage.) If I want to hold on to them by restoring the old 26 percent rate of return, I will have to raise the "pre-tax" return by investing in a higher-yielding loan portfolio. Specifically, the portfolio will have to earn over 11 percent -- not 10 percent -- to maintain competitive returns. Unfortunately, the only way to generate consistently higher returns is to absorb consistently higher risk.

What should one think about this unintended consequence of making the bank safer? The official response to this dilemma is to impose a series of specific capital charges (i.e., new taxes) on riskier investments to control the incentive effects of the original policy. Who knows where it ends, and the cascading of taxes carries increasingly higher costs.

The history of finance has revealed a fundamental benefit from sound prudential regulation. In reality, sound regulation acknowledges the economic costs, as well as the benefits, of making institutions safer. An unfortunate residue of the financial crisis is the notion that no bank can be too safe, all regulations are unambiguously good, and the balance of benefits and costs is preordained in the regulatory process.

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