Last week the president of the Federal Reserve Bank of Minneapolis gave a speech containing statements about large banks and the government’s response to the COVID-19 pandemic. A number of these statements are at complete odds with facts and broad consensus views. Below, we identify seven statements made in the speech and point out why they are factually inaccurate or ill-considered.
- Large banks just continue to get larger as the 10 largest bank holding companies in America are around 45 percent larger than they were in 2008. While banks complain that regulations are hurting their competitiveness, the data show otherwise.
The entire economy and banking system have grown since 2008. As a result, it is misleading to cite the growth in the nominal size of the 10 largest banks in isolation. Rather, what matters is their share of the overall banking sector. The share of the 10 largest banks has, in fact, declined since 2008. Data from the Federal Reserve show that the 10 largest bank holding companies’ share of total banking sector assets declined from 64.9 percent to 59.7 percent between 2008 and 2020. Accordingly, as a share of the banking sector, large banks have become smaller and not larger since 2008. Moreover, the non-bank financial system has grown more rapidly than the banking sector since 2008. As a result, the 10 largest banks’ share of total financial system assets has declined by even more.
- Large banks—particularly Global Systemically Important Banks, or GSIBs—in America today are still too big to fail, and their capital levels are not high enough to balance the benefits society gains from their scale with the risks they pose to the economy. Analysis shows clearly that large banks should fund themselves with equity of at least 24 percent of risk-weighted assets.
This perspective is an outlier and does not reflect the consensus views of academics and other people who think seriously about banks and banking regulation. In particular, the chairman of the Federal Reserve has publicly commented that no U.S. bank is too big to fail. Expert academics have also come to this conclusion. As an example, Darrell Duffie of Stanford University—a leading expert on the banking system—and his colleagues recently issued an academic research paper that finds that “G-SIB creditors now appear to expect to suffer much larger losses in the event that a G-SIB approaches insolvency. In this sense, we estimate a major decline of ‘too big to fail’.”
On bank capital, serious analysis does not support a capital ratio of 24 percent. A recent, peer-reviewed, research paper that has been accepted for publication in one of the world’s most revered economics journals found that a bank capital ratio of 25 percent would impose a cost on the economy of $6 trillion. Accordingly, a 24 percent capital requirement is simply not a serious proposal.
- Large U.S. banks contend that they will be at a competitive disadvantage if other countries don’t adopt equivalent capital regulations. But this assertion is false because U.S. banks are outcompeting foreign banks that have even more lax regulations.
The statement that higher capital requirements for U.S. banks do not create a competitive disadvantage does not logically follow from the statement that U.S. banks are outcompeting foreign banks. U.S. banks outperform foreign banks for a number of reasons, many of which relate to fundamental differences between U.S. and foreign economies. Rather, U.S. banks outperform foreign banks despite being handicapped by higher capital requirements.
- Large U.S. banks contend that the U.S. economy benefits from their large economies of scale and that will be lost if they are forced to issue more equity, because they will choose to become smaller when faced with higher capital requirements. This is false because if they exhibit economies of scale, then they should be able to afford higher capital levels.
This statement is incorrect and does not comport with basic economic principles. All companies—including banks—make adjustments to respond to higher costs. Companies do not absorb higher costs because “they can afford it.” A fundamental principle of economics is that firms respond to their cost structure. If bank capital costs rise with size, then banks will take this into account as they choose their size footprint.
- Perversely, large banks maintain much lower levels of capital than small banks. This is not sensible as large banks should maintain higher levels of capital than small banks.
The statement that large banks maintain much lower levels of capital than smaller banks is not correct. Specifically, according to data from the Federal Reserve Bank of New York, since 2016, bank holding companies with more than $750 billion in total assets maintained an average Tier 1 capital ratio of 14.1 percent while banks and bank holding companies with total assets less than $50 billion maintained an average Tier 1 capital ratio of 13.5 percent. Moreover, over this period, large banks exhibited a higher capital ratio in 16 out of 17 quarters. Accordingly, since 2016 large banks have maintained, on average, a higher capital cushion than small banks.
The same data also show that further back in history, smaller banks maintained more capital than large banks. But this fact is not perverse and is a well-understood feature of the banking sector. Specifically, it is well-known that small banks are less well-diversified, exhibit more concentrated exposures, and are therefore more vulnerable to local or national downturns than large banks. In fact, from time to time regulators call attention to the concentrated and undiversified nature of some smaller banks as the FDIC did in this 2019 report, in which it highlighted concentration risks in the commercial real estate holdings of smaller banks. In addition, the broad-based and well-diversified nature of large banks is also well-understood. As we recently noted, the Federal Reserve’s stress test results show that Forum members are the most well-diversified banks subject to the stress tests.
- Large U.S. banks contend that lending will be curtailed if they have to fund themselves with more equity. But until recently, they were buying back billions of dollars of their stock each year. If capital was constraining lending, then banks should not be repurchasing their own equity.
Equity is more expensive than debt. All mainstream economists recognize this and agree that lending is less beneficial when it has to be financed with more expensive equity and, as a result, the amount of lending will decline. This is simply a specific instance of the general economic principle that if something becomes more costly then less of it will be produced. Share repurchases are a means of distributing bank earnings to investors. Indeed, distributing a significant share of earnings back to investors through repurchases is itself an indication that the returns to bank lending are low and that investors can do better by reinvesting the cash received from share repurchases outside the banking sector. Accordingly, share repurchases may themselves be a sign that high capital costs are constraining lending.
- The government’s response to the COVID-19 pandemic is a bank bailout.
This statement is simply specious. The government’s response to the COVID-19 pandemic is not a bank bailout. Rather, it reflects a broad-based and coordinated government response to a global health pandemic that has ravaged people and businesses throughout the entire economy. Across the nation, small businesses, households and large companies in a broad range of sectors have benefited from the government’s response to the pandemic. And while it is certainly true that all banks are tied to the economy and affected by economic downturns, it is simply incorrect to characterize such broad-based efforts as a “bank bailout.” Finally, this characterization is especially misleading given the significant strength of the banking sector as well as the important work that large and small banks have been doing to support the government response, as has been recently recognized by the chairman of the Federal Reserve. Also, as we have recently noted, large banks have led the way in lending to businesses, providing households with safe deposits during these uncertain times, and helping public companies to raise much-needed funding during this public health crisis.
In the past 12 years, the bank regulatory regime has been significantly strengthened and large banks have led the way by substantially raising their levels of capital and liquidity. These improvements are a big part of the reason why large banks have been a source of strength during the COVID-19 pandemic. Suggestions to the contrary, including those profiled above, are not consonant with this basic reality and should not be taken at face value.