Over the past ten years, large banks have greatly increased their capital – both in sheer dollar terms and as a fraction of risk-weighted assets – in response to a number of capital reforms such as Basel III, implementation of the GSIB surcharge and stress tests. At the same time, like any resource, bank capital is not free and using more of it imposes a cost on society. Regulators have largely taken the position that large bank capital levels are now “about right” as Federal Reserve Chairman Jay Powell offered in Congressional testimony last July. In this post, we highlight new research from economists at Columbia Business School, Johns Hopkins Carey Business School and the Wharton School at the University of Pennsylvania that challenges this view. This new research finds that the level of capital requirements that best serves the economy is roughly half the level maintained by Forum members today. The research finds that current capital requirements permanently reduce GDP and economic welfare and impose a total cost on the economy of about $1.4 trillion.
In their paper, the authors consider the impact of bank capital regulation in a quantitative, data-based macroeconomic model that considers all of the relevant interactions between the banking sector and the macroeconomy. In particular, the economic model explicitly recognizes that banks lend in the real economy to finance investment and growth. This paper is important because it is one of the first peer-reviewed research papers to explicitly consider all of these important interactions in a rigorous model that is disciplined by empirical data.
In their model, as bank capital regulation tightens, banks are forced to fund loans with more equity, which is more expensive than deposits. These higher funding costs are passed onto firms that borrow from banks and these firms respond to higher costs by reducing investment. As a result, the size of the banking sector shrinks, which leads to a smaller and less prosperous economy. In addition, and importantly, with a smaller banking sector, the total capacity of the banking sector to provide deposits to households also shrinks and households have less access to deposits as a store of value, which represents a further cost of higher capital requirements. Taking all of these considerations into account, the model determines the level of capital requirements that maximizes the economic welfare of households. In Figure 1, we present the model’s estimated optimal level of required capital and the level of capital maintained by Financial Services Forum members.
As shown in Figure 1, the optimal level of capital is roughly 6% of risk-weighted assets. As of Q2 2020, Forum members maintain a capital ratio that is roughly 12% of risk-weighted assets. Accordingly, this research implies that current capital levels are roughly twice the level that best serves the economy.
In considering this result, it is important to appreciate the impact that higher capital requirements have on the size of the banking sector and, ultimately, the economy. As the authors state: “The intermediary sector shrinks dramatically and persistently. The reduction in credit supply feeds back on the real economy and depresses investment and output.” This finding shows the important and strong linkage between the banking sector and the real economy. Capital regulation does not impact banks in isolation. Rather the effect of capital regulation flows through to impact the whole economy. Importantly, in addition to less output, a smaller banking sector has a diminished capacity to provide bank deposits to households when capital requirements are too high. As a result, households that rely on bank deposits as a savings vehicle are negatively impacted by higher capital requirements. As the authors put it, “a smaller banking sector reduces deposits and thereby the wealth of savers.”
Excessive Capital Requirements Have Large Economic Costs
The research shows that current capital levels are roughly twice the level that best serve the economy. But what exactly is the cost to the economy of capital requirements that are too high? The authors offer a data-based estimate of the costs, and it is large. Specifically, the authors calculate the amount of additional GDP that the economy would have to produce and be provided to households to make them willing to accept higher capital requirements. The higher the amount of additional GDP that is required, the more costly are increased capital requirements. Figure 2 presents the amount of additional GDP that would have to be provided to households to make them indifferent between optimal capital requirements and higher capital requirements of 9% and 12%.
As shown in Figure 2, a capital level of 9% would require about an additional $500 billion in GDP. A capital level of 12%, the current situation, would require an additional $1.4 trillion in GDP.
Finally, it should be noted that the costs depicted in Figure 2 are net costs after accounting for all of the benefits of higher capital. Specifically, the cost estimates explicitly account for the fact that more capital makes banks safer and bolsters financial stability. The costs depicted in Figure 2 indicate that the negative consequences of excessive capital requirements – a smaller banking sector, less lending and output, less deposit availability – outweigh the benefits. As a result, these costs should be taken seriously as a research- and data-based measure of the overall costs of excessive capital requirements.
Capital Requirements and Non-Bank Financial Intermediation
One limitation of this new research paper is that the model subjects all banks to the same capital requirements. In reality, non-bank financial institutions provide bank-like services without the same level of prudential regulation. One possible implication of the authors’ research is that current capital requirements create large incentives for non-banks to grow and offer financial services because growth in the banking sector is constrained by capital regulation. According to the Financial Stability Board, non-bank financial institutions have grown at roughly twice the rate of the banking sector globally since 2012. Accordingly, excessive capital requirements that constrain the banking sector may play a role in stoking the growth of less-regulated, non-bank financial intermediaries.
All banks need capital to remain safe and sound and support the economy. Forum members are committed to maintaining robust capital levels that will allow them to support the economy. At the same time, the United States has undergone a significant change in capital policy over the past decade. The macroeconomic effects of this change on capital levels are important because capital requirements directly influence the availability of credit, savings vehicles for households, and the ability of our economy to grow. Regulators and the public should continually examine whether the large shift in capital policy has struck the right cost-benefit balance. New research suggests that current capital requirements do not strike the right balance and impose a total cost on the economy of about $1.4 trillion. In addition, excessive capital requirements may be fueling the growth of less-regulated, non-bank financial intermediaries. Of course, no single research paper is ever conclusive, but these new results provide important food for thought because they suggest that current requirements are too high and that the economic costs are material.