Capital Requirements, Borrowing Costs, and the Economy

26 Oct 2020
Read Time 5 mins
Categories :
Bank Capital
, Liquidity
, Resiliency

All banks need robust capital levels to remain safe and sound and to support the economy and lending to households and businesses. Indeed, Financial Services Forum members have increased their capital significantly over the past several years and today maintain $832 billion in high quality capital. Moreover, as we will detail below, Forum members currently maintain even more capital than is required by the Federal Reserve’s new stress capital buffer requirement that was finalized in March of 2020. Accordingly, Forum members are safe, strong and well positioned to support growth in the economy. At the same time, it is important to consider the impact that capital requirements have on the cost of borrowing and the overall economy. In this note, we briefly discuss research from the Federal Reserve Bank of Philadelphia that reviews a range of mainstream economic research papers and provides a summary measure of the impact of heightened capital requirements on the cost of borrowing and economic output. The study finds that a one-percentage-point increase in bank capital requirements reduces economic output by between $30 billion and $120 billion dollars each year.

Forum Members Maintain Robust Capital Levels

Table 1 depicts the aggregate amount of high-quality capital (common equity tier 1 capital, or CET1) in both dollar terms and as a percentage of risk-weighted assets maintained by Forum members as of the end of the third quarter of 2020. Table 1 also depicts the total amount of capital that is required to be maintained according to the Federal Reserve’s stress capital buffer (SCB) rule. The stress capital buffer rule was finalized by the Federal Reserve in March of 2020 and represents the most current and up-to-date methodology for assessing the capital needs of large banking organizations. Importantly, the new rule incorporates the Federal Reserve’s stringent and risk-sensitive stress testing regime into the capital requirement. 

Source: Bank Earnings Releases

As shown in Table 1, Forum members currently maintain $832 billion in CET1 capital, which is $146 billion over and above the Federal Reserve’s SCB requirement of $686 billion. On a percentage basis, this amounts to more than two percentage points of excess capital. This degree of capital adequacy is robust. A study from the International Monetary Fund concludes that a capital level of 6 percent would have been sufficient to cover the losses at the peak of the financial crisis, half of what Forum firms now maintain. Accordingly, current capital levels demonstrate that Forum members are sound, strong and well poised to lend and support the economy.

The Economic Cost of Higher Capital Requirements: More Capital is Not Free

In light of the data in Table 1, it is natural to ask whether regulators should require even more capital from large banks. One might reason, for example, that if requiring $686 billion of capital leads to safe and sound banks then perhaps requiring, say, $700 billion in capital would be even better? If there were no costs to raising and maintaining capital, this logic would be correct. In both theory and practice, however, this logic is incorrect because increasing capital imposes a cost on society because capital is a more expensive form of finance than deposits or other forms of bank debt. As a result, as the amount of capital required by regulators increases, so too do the costs imposed on the economy in terms of higher borrowing costs (higher interest rates on car loans, home mortgages and credit cards), as well as economic output and jobs. Moreover, in light of the substantial capital levels of Forum members, at some point requiring even higher capital requirements acts as an unnecessary impediment to economic growth.

One research paper that puts this issue in perspective is “Are Higher Capital Requirements Worth It?” by Pablo D’Erasmo of the Federal Reserve Bank of Philadelphia. This research paper reviews a number of economic research studies and summarizes the findings on the cost of raising capital on borrowing rates and the economy. This paper is useful because it reflects a broad range of economic research and isn’t tied to the findings of any particular study. Table 2 below depicts the cost of heightened capital requirements in terms of increased borrowing rates and decreased economic output (GDP) as summarized in the paper. As shown in Table 2, every 1 percentage point increase in bank capital requirements is expected to raise borrowing costs by 0.05-0.15 percentage points (5-15 basis points) and reduce economic output by 0.15-0.60 percent.

A few points about the impacts cited above are worth noting. First, these costs are long-lived. As an example, if regulators were to increase bank capital requirements today then the cost of, say, a 30-year mortgage would be higher now and each year in the future and economic output would be lower in the current year and all future years as long as capital requirements remain elevated. Second, these costs are not small. In the case of borrowing costs, D’Erasmo states that “it is reasonable to expect that increases in borrowing costs of this magnitude may curtail lending enough to create a lasting drag on overall economic activity.” In the case of economic output, a 0.45% decline in output in today’s U.S. economy amounts to roughly $90 billion in lost output each year, which is substantial. Accordingly, the costs associated with heightened capital requirements should be taken seriously by regulators and the public.

Conclusion

Forum members maintain robust capital levels. As of Q3 2020, Forum members maintain $832 billion in high quality (CET1) capital. This amount of capital exceeds the amount required by the Federal Reserve’s SCB requirement by $146 billion. This degree of capital adequacy means that Forum members are safe, strong and well-positioned to support our economy. At the same time, regulators and the public need to carefully consider the costs of higher capital requirements. More capital is not always better because higher capital requirements impose a real cost on society. This finding is not new or controversial. Rather, it is consistent with mainstream economics and these costs have been quantified in a wide range of research studies published by academic economists, central banks, and global regulatory bodies. A research survey by the Federal Reserve shows that economists generally find that every one percentage point increase in capital requirements reduces economic output by between 0.15 and 0.60 percent, which translates to a cost of between $30 billion and $120 billion dollars each year in today’s U.S. economy. In light of the substantial capital levels of large banks regulators and the public should seriously consider the costs of any further increases in capital requirements.

Forum Updates