Required Intellectual Capital

By Simon Johnson
At one level, the pursuit of higher and more robust capital requirements for banks is not going well.  The US Treasury insisted, throughout the year-long financial reform debate, that capital should be the focus – increasing the loss-absorbing buffers that banks must carry – and that they (and other regulators) needed to negotiate this is through the Basel Committee process.
But Basel has some under great pressure from the banking lobby, which argues that any increase in capital requirements would limit lending and slow global growth (see this useful background by Doug Elliott).  The Institute of International Finance (IIF) – a lobby group for big banks – issued an influential “report” along these lines and the European stress test results strongly suggest that Euroland politicians do not want to press more capital into their financial system – “just enough” would be fine with them.
However, at another level – in terms of the analytical consensus around these issues – there is a great deal of progress in the right direction.  In particular, an important new paper by Samuel Hanson, Anil Kashyap, and Jeremy Stein, “A Macroprudential Approach to Financial Regulation” pulls together the best recent thinking and makes three essential points.  (This is a nontechnical paper written for the Journal of Economic Perspectives – it’s a “must read” for anyone interested in financial sector issues but requires some effort and a little jargon does creep in.)
First, if we are really to apply the much discussed new “macroprudential” approach to regulation, we need to get much more serious about capital requirements.  In the past, regulators only cared if each bank – by itself – had enough capital to withstand likely losses.  But experience over the past few years has made it completely clear that this is not enough. 
The “macroprudential” view, articulated nicely here, is that we should worry about banks being forced to dump assets in order to reduce their balance sheet – capital requirements are usually stated as the ratio of “capital” (ideally this would be shareholder equity; this link provides more detail) to total assets.  Forced sales can cause asset prices to decline sharply – feeding into exactly the problems we saw in 2007-08, and eventually leading to the near complete collapse of the market for asset backed securities.
Individual financial institutions, however, do not care enough about the systemic effects of their actions – these costs are “externalities” to their decision-making.  But from a social point of view this is a big deal and an important reason why the recession of 2008-10 was so severe.  We should therefore have substantially higher capital requirements than heretofore – presumably far above what regulators currently have in mind.
Second, we should really set capital requirements for types of assets not – as is done currently – by types of lenders.  Banks obviously have an incentive to “leverage up”, meaning to borrow more relative to their equity.  If we regulate banks, these same transactions will migrate to other more shadowy parts of the financial system.
Probably the most innovative part of authors’ proposals is that we should set higher margin requirements against asset-backed securities.  Allowing anyone – irrespective of what you call them – to borrow heavily against such assets is simply not a good idea.  Unfortunately, this approach is completely absent from the current regulatory reform toolkit.
Third and perhaps most important for the continuing policy debate, the authors are quite clear: There is no evidence that increasing capital requirements – if handled in the right way – would have significant adverse effects on credit available to the nonfinancial sector or on economic growth and employment.
The policymaker consensus is unfortunately in a different place on this – unduly swayed by the IIF and other representatives of global banks.  But Hanson, Kashyap, and Stein are careful and categorical – shifting from debt towards more equity financing for banks would have, at most, a small effect on interest rates for loans.  The IIF and its allies are plainly and obviously wrong on this issue.
The authors are leading financial experts and, as a result, carry a great deal of weight in policy circles.  Stein is a professor at Harvard, former president of the American Finance Association and a sometime adviser to the Obama administration.  Kashyap is a professor at Chicago, and has written authoritatively on the financial rise and fall of Japan, among other things.  Samuel Hanson is an up-and-coming graduate student at Harvard.
They do not in this paper spend much time explicitly on the political economy of capital requirements and the broader regulatory framework for banks in the US or around the world.  But implicit in their analysis is the sensible idea that banks and other powerful financial players are not passive “rule takers” – the finance industry has spent a great deal of time and treasure in recent decades undermining what these authors would regard as sensible rules.
And the same global banks are working hard to undermine the Basel process, so far to great effect.  Hanson, Kashyap, and Stein have helped move our thinking in the right direction.  But the stark contrast between their views and the political/regulatory reality on the ground only highlights how much further we need to go.
An edited version of this post appeared this morning on the NYT.com’s Economix; it is used here with permission.  If you would like to reproduce the entire article, please contact the New York Times.