Inside Financial Services

Washington Should Listen to the OCC’s Walsh

Regulators will do more harm than good if they force overly high capital standards on the banks.

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Among banking regulators, only acting (Acting? What’s taking President Obama so long?) Comptroller of the Currency John Walsh seems to understand that a key way to ensure the banking system is healthy and capable of creating the credit needed for economic growth is to not lard it down with onerous, redundant capital requirements:

Large U.S. banks have already raised large amounts of capital since the peak of the crisis and are very highly capitalized by traditional measures. We expect that these increases in actual capital levels, combined with an extended phase-in period for the higher capital standards of Basel III, should allow banks to transition to the higher capital requirements in a reasonable manner without causing undue stress on the current economic recovery. However, we are concerned with how much more we can and should turn up the dial on our banks without having negative effects on lending. Our concerns on this front are most evident in the context of the surcharges being contemplated for systemically important firms . . . . [Emphasis added]

Amen, brother! Overly high capital standards will crimp lending. Unfortunately, there seems to be a weird bidding war among other banking regulators to see who can come up with the most draconian capital proposal. Fed governor Daniel Tarullo helped sparked market a mini-meltdown last week when he suggested that minimum Tier 1 capital ratio might have to be as high as perhaps 14.5%. Anat Admati, an ivory-tower professor from Stanford, has gotten regulators’ ears with her proposal that minimum capital ratios be as high as 20%. Sheila Bair is of course off the charts; all she says is, “the higher, the better.”

Easy, fellas! Fact: for a given amount of capital, higher capital ratios mean smaller balance sheets, which means less lending, which means many worthwhile businesses won’t be able to get financing. Economic growth will slow. (As an alternative, the bank can maintain its size by raising additional capital, but that new capital won’t be cheap.)

I am astonished that the industry’s regulators don’t understand this. What’s more, if they really do want a real-world sense of how much capital would be enough to get the industry through even in a worst-case scenario, all they have to do is look at the crunch just past, and see how much turned out to be enough. If you do that, you see that a number like, say, 14.5% is way, way too much. (Side observation, which I suspect I’m going to have to keep repeating until I’m blue in face: it wasn’t lack of capital that brought a lot of big institutions low during the crunch. It was a lack of liquidity. Wobbly banks were done in by old-fashioned runs.)

And even the OCC’s Walsh, who seems to have his screwed on straight on the minimum-capital issue, seems a bit dreamy-eyed on how some of his ideas would play out in the real world. Take this, for instance:

[Basel III sets] a 2.5 percent conservation buffer of capital above the 4.5 percent minimum requirement, bringing the total requirement to 7 percent. This capital buffer is intended to ensure that banks are well-positioned to withstand economic downturns or stresses that are unique to their portfolio. For example, a bank that had capital equal to, or in excess of, 7 percent of risk-weighted assets during strong economic times might dip into its buffer during a period of economic stress, while still maintaining capital levels that should not lead to concerns about its viability. Though the capital buffer could be used during a period of stress, there also would be a constraint associated with that use. One of the consequences of dipping into the buffer would be progressively more stringent capital distribution restrictions as the bank’s capital levels erode and approach the minimum thresholds.

This formulaic response to falling capital levels will create the appropriate incentive for banks to maintain a healthy buffer during benign economic times, and also limit the ability of banks to dissipate capital when their capital ratio is deteriorating. . .

There’s just one problem with this save-the-capital-for-a-rainy-day plan. In the heat of the moment during a “period of economic stress,” regulators will have plenty of “concerns about the viability” of banks eating through capital, whether you want them to worry, or not. You can also count on regulators forcing those banks to raise additional capital at the very bottom of the cycle. It happens every time. The capital raises following the stress tests of the big banks in 2009 are only the most recent and egregious example. Walsh can assume regulators won’t panic during the next downturn. But, of course, they will.

But overall, Walsh has a much more realistic and reasonable view of what banks minimum capital should be. His colleagues would do well to pay attention.

What do you think? Let me know!

9 Responses to “Washington Should Listen to the OCC’s Walsh”

  1. puredakota

    I am a big proponent of a safe and sound banking system. And I’ve always believed that capital flows toward opportunity. So I have been wondering about the coherence of a policy that reduces the opportunity for profit, while at the same time mandates higher capital. I must be getting dense in my older years. Can someone explain how this works?

  2. puredakota

    I am a big proponent of a safe and sound banking system. And I’ve always believed that capital flows toward opportunity. So I have been wondering about the coherence of a policy that reduces the opportunity for profit, while at the same time mandates higher capital. I must be getting dense in my older years. Can someone explain how this works?

  3. Jim C.

    Mr. Walsh should also ensure that his on site examination teams aren’t going overboard in their efforts to fight the last battle/make up for their faliure to EFFECTIVELY supervise in previous years.

  4. 6200High

    The problem isn’t lending activities, it’s high risk trading activities which should be supported by higher capital. If we were only concerned about traditional lending, I would agree that higher capital requirements are unnecessary. Unfortunately, we now include in our definition of “banks” those institutions that used to be known as ‘investment banks”. Their businesses models are built to a much greater extent than in the past on trading not lending. These activities should be required to hold higher capital if these institutions expect to have access to the Fed.

  5. Ninetynine

    Unfortunately Walsh’s comments signal that he knows he is on the way out.

  6. tom olson

    There is no realistic amount of capital that will make a bank safe if their underwiting is undisciplined.

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