U.S. banks would need to have significantly more capital to adequately protect against the possibility of a financial crisis and risk of a recession, according to a new study that runs counter to the Obama administration’s claims that banks are well-capitalized.
Banks should have capital equal to 6.6-7.9 percent of assets to balance the benefits of avoiding a damaging financial crisis against the costs of slower bank lending, the paper published by the Peterson Institute for International Economics found. The Peterson Institute is a nonprofit think tank in Washington.
The eight biggest U.S. banks had an average of 5.73 percent of comparable capital last year, according to an index created by Federal Deposit Insurance Corporation Vice Chairman Thomas Hoenig.
In other words, big banks such as Bank of America, Goldman Sachs and Morgan Stanley would have to increase their capital levels by as much as 40 percent, on average, to be adequately capitalized.
Higher capital levels mean that banks rely less on borrowing and more on investors to fund the loans they make to borrowers. Higher capital is thought to make a bank safer because investors have more at stake and watch the executives more closely and because the bank can lose more money without risking defaulting on its debt.
Obama administration officials and financial regulators have pointed to the significant increase in capital throughout the banking system as a sign that the financial system is safer now than it was before the financial crisis. In recent weeks, President Obama and others in the administration have rebuked critics who have suggested that little has been done to reform banking, citing new capital rules in particular as a reason for confidence.
The Peterson Institute paper, written by fellow William Cline, examines what the right level of capital would be, given the cost to the country of a banking crisis that it places at about two-thirds of economic output. That is in the same ballpark as a Federal Reserve Bank of Dallas estimate that placed the cost of the 2008 crisis as high as one year of economic output, which is commonly measured using gross domestic product.
Balanced against the benefit of avoiding another such disaster by making banking safer is the cost of the higher interest rates on loans from banks that would result from higher capital. The trade-off comes at 6.6-7.9 percent of a restrictive definition of capital, the paper finds.
Many of the new capital rules vary the level of capital required depending on the riskiness of the assets held by the bank. For instance, loans to businesses require more capital than holdings of U.S. Treasury bonds. The new Basel III capital rules require capital of 7 percent of risk-weighted assets, but the paper concludes that it should be 12 or 14 percent.
Just how high capital levels should be is an ongoing debate, and one that cuts across party lines.
Last Congress, Sens. Sherrod Brown, D-Ohio, and David Vitter, R-La., introduced legislation that would set a capital requirement for big banks of 15 percent.
