Regulators don’t want banks to go bust in the next financial crisis, or even come close. So they’re requiring them to carry thicker safety cushions of “capital,” that miraculous loss-absorbing material.
So what exactly is capital? Sometimes it’s described as a rainy-day fund, which is wrong. More often it’s characterized as something banks “hold,” which can make it sound like a pile of money that has to be set aside so it can’t be lent out for a profit. That’s not right either.
Put simply, capital is nothing more than the difference between what banks own (assets) and what they owe (liabilities). Assets include loans the bank makes, which produce interest income, along with bonds, deposits at the Fed, and cash in the vault. Liabilities are other people’s money that banks are allowed to play with, including deposits by their customers. A bank with a large capital cushion could sell its assets, return all its depositors’ money and pay off other borrowings, and have money left over.
Capital is in the news because the Federal Reserve is getting ready to announce the extra amount of capital that the biggest banks will be required to have because their hugeness poses a risk to the financial system. The extra cushion could be as much as 4.5 percent of “risk-weighted” assets on top of the target of 7 percent agreed to by the 27-nation Basel Committee on Banking Supervision, according to a person briefed on the matter who requested anonymity because he is not authorized to speak publicly. “We’re all trying to come to grips with what we really need in order to provide more assurance that these firms do not threaten the financial system,” Fed Governor Daniel Tarullo told the Senate Banking Committee on Sept. 9.
It’s easy to get lost in the weeds once the capital debates begin. The concept of risk-weighting in the Basel accords is that banks don’t need a thick capital cushion if most of their money is tied up in safe assets like Treasury bonds. The leverage ratio is a cruder measure that sizes up capital against all assets regardless of their riskiness.
Keep your eye on the main point, which is that capital isn’t an inert lump of money. The American Bankers Association says that higher capital requirements for big banks “reduce economic and job growth.” But banks can meet capital requirements without cutting back lending. They just have to sell more shares (cutting down on buybacks also works) or reduce cash-draining dividends (refraining from raising them also helps). Banks that don’t want to thicken their safety cushions benefit from the public’s mistaken mental image of capital, says Anat Admati, a professor at Stanford University’s Graduate School of Business who is crusading for banks to have more of it. John Cochrane, a professor at the University of Chicago Booth School of Business, agrees, saying it’s wrong to describe capital as “costly” or to say banks must “hold” it. Wrote Cochrane in a Sept. 10 blog post: “The PC [politically correct] left has a point: Little words do matter.”