How do you solve a problem like bank capital? How do you hold a moonbeam in your hand?
Fed Governor Daniel Tarullo said today that banks should be made to hold more capital, maybe even more than Basel III requires, in order to avoid another financial crisis.
Earlier, Deutsche Bank analyst Matt O’Connor, who is employed by a bank, warned that forcing banks to hold too much capital could backfire — that maybe even making them hold as much capital as Basel III requires could be too much.
Banks could charge more for loans, he warned, hurting consumers and small businesses. They might also take even bigger risks in order to generate more return, creating the possibility of an even bigger financial crisis:
If one assumes an increase in required capital would need to be offset by a repricing of loans, we find each 1% increase in capital adds 25-35bps to the cost of credit. This would impact consumers and small business loans the most as they have fewer borrowing options than large companies. The other option is for banks to take on MORE risk (in search of higher yields) to offset the impact of higher capital. This occurred during the mortgage boom leading up to the crisis as banks held higher risk mortgages/securities given spreads on higher quality loans became so narrow (relative to required capital).
Mr. Tarullo sort of addressed those points in his remarks today. He suggested that, if banks held more capital, then investors would require less return on equity, meaning bank stock prices might be higher. I’m going to go ahead and add that maybe bank borrowing costs could be lower, too.
Would this lower cost of capital be enough to satisfy the banks? I’m going to go out on another limb and guess no.
In another interesting part of his note, Mr. O’Connor estimated the Tier 1 capital ratios for several banks under Basel I and Basel III capital requirements, a measure of how far the gulf is between the two for the banks.
- At the end of the first quarter, Citigroup had a 6.1% or 6.2% ratio under Basel III, compared with a 12.3% ratio under Basel I.
- Bank of America had a 4.6% ratio under Basel III, compared with an 8.6% ratio under Basel I.
- And J.P. Morgan Chase had a 7.3% ratio under Basel III, compared with 10% under Basel I.
- Wells Fargo was the closest among the Too Big to Fail set in matching ratios under the two different regimes, with 7.2% under Basel III and 8.9% under Basel I.