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Capital matters.
Let me put that another way. The current fight over additional capital requirements for the banking industry, eye-glazing though it is, also happens to be the most important reform moment since the financial crisis broke out three years ago. More important than the wrangling over Dodd-Frank. More important than the ongoing effort to regulate derivatives. More important even than the jousting over the new Consumer Financial Protection Bureau.
If investment banks like Merrill Lynch had had adequate capital requirements, they would not have been able to pile on so much disastrous debt. If AIG had been required to put up enough capital against its credit default swaps, it’s quite likely that the government would not have had to take over the company. If the big banks had not been able to so easily game their capital requirements, they might not have needed taxpayer bailouts. A real capital cushion would have allowed the banks to absorb the losses instead of the taxpayers. That’s the role capital serves.
Adequate capital hides a plethora of sins. And because, by definition, it forces banks to use less debt, it can also prevent sins from being committed in the first place. “There is no credible way to get rid of bailouts except with capital,” says Anat Admati, a finance professor at Stanford Business School and a leading voice for higher capital requirements.
“The only cure is capital,” says Daniel Alpert, a founding managing partner of Westwood Capital. Recently, The Wall Street Journal wrote an editorial applauding the recent suggestion by Daniel Tarullo, a Federal Reserve governor, that the biggest banks hold as much as 14 percent of assets in capital. I couldn’t agree more.
Which is why a recent hearing by the House Financial Services Committee was such a sorry sight. Under the guise of examining whether the new financial regulations—including proposed capital requirements—were making U.S. banks less competitive, the Republican majority peppered U.S. regulators, including Tarullo, with skeptical questions about the need for increased capital requirements. It was pathetic.
I should point out that the proposed international standards—Basel III, as they’re called, which are still being negotiated by regulators around the globe—would require banks to hew to capital requirements of only 7 percent, not 14 percent. They are also talking about adding capital surcharges of up to 3 percent, on a sliding scale, to the 30 largest, most systemically important institutions worldwide, meaning that JPMorgan Chase, for instance, would have capital requirements of 10 percent.
There are many experts, including Admati and, one suspects, Tarullo himself, who think this is still too low. The Basel committee has already agreed, somewhat absurdly, to delay the implementation of the requirements until 2019. (Good thing the world’s banks aren’t going to have any big problems between now and then!) And because the Basel standards, whatever their final form, must still be enacted and enforced by individual country regulators, there is no guarantee that every country will agree to them.
But the U.S. should, no matter what other countries do. Banks always want capital requirements to be as low as possible, because the less capital they have, the more risk they can take and thus the more money they can make (and the bigger the executives’ bonuses). But so what? Trading some bank profits for a safer financial system is a deal most Americans would take in a heartbeat.
Indeed, every argument put forth by the big banks and their congressional spokesmen against higher capital requirements have been demolished by Admati as well as Simon Johnson, the banking expert. But the idea that they will make U.S. banks less competitive with European banks deserves particular scorn.
European banks, to be sure, have fought fiercely against higher capital requirements. It’s not really because they hope to get a leg up on the rest of the world, though. It is because these banks are in far worse shape than the banks in other parts of the world; they can’t afford higher capital requirements.
If Europe began insisting that its banks begin holding enough capital to cushion against all the risk on their books—starting with Greek debt—the truth would be out: Their insolvency would suddenly be apparent. If Europe wants to keep kicking the can, by turning its back on the surest measure to increase the safety of its financial system, why on earth would we want to go along?•
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Nocera is a New York Times columnist. Send comments on this column to ibjedit@ibj.com.
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