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Let Banks Manage Risks, Not Regulators

Authored by Steve H. Hanke of the Johns Hopkins University. Follow him on Twitter @Steve_Hanke.

No one knows yourself better than you do. The same concept applies with financial institutions and the risks they take. An outside entity will never understand the day-to-day operations that occur within the walls of a bank; moreover, the calculated risks that a financial institution takes when investing is best understood by the financial institution itself, not the government or any outside party. Shouldn’t these banks, therefore, determine how to utilize their capital if they are the ones who best understand the risks they take?

In the last few years, a consensus for higher bank capital ratios has been established among politicians at the highest levels, in international financial circles, and among many of the respected academics working in this field. For example, in 2013, Anat Admati and Martin Hellwig published a new book, The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It. In it, they advocate for substantial increases in capital ratios over and above the figures mandated under Basel III. The book was praised by Nobel laureate, Roger Myerson, who described it as being "worthy of such global attention as Keynes' The General Theory." But, is it necessarily true that banks with more capital are safer and stronger, and hence more resilient in coping with cyclical shocks? Even Lehman Brothers, which was incidentally not a bank, had a capital cushion that comfortably exceeded the regulatory minimum just before it went bankrupt. Unless regulators are so intrusive as to undermine the autonomy of bank management altogether, there is always a risk that banks will acquire assets of such low quality that high capital buffers would fail to protect depositors. 

Since 2009, the reaction of most banks to the new regulatory frenzy has been to run scared. They have restricted claims on the private sector and expanded low-risk holdings of cash reserves and government securities. (Under the Basel III rules, cash and government securities require no capital backing as they are deemed to be “risk-free”). The new difficulties that companies face in raising finance from the banking industry may hamper growth and innovation, as even the IMF and the OECD sometimes quietly acknowledge. Since bank credit lines are a key source of working capital for some businesses—notably those which trade products, commodities, and securities—the restriction on credit has acted as a pro-cyclical, supply-side constraint on the economy. For all the talk about the looseness of the Fed’s monetary policy in the QE era, the inconvenient truth is that overall broad money growth in the U.S. has remained rather subdued since 2008. 

By enforcing extra bank capital requirements in the middle of an economic downturn (that is, in late 2008 and 2009), central banks and the main regulatory agencies aggravated the cyclical weakness in demand. For a few quarters, the resulting depression in asset prices made some banks even less safe, illustrating the warning by Irving Fisher in his 1933 book, The Debt-Deflation Theory of Great Depressions. As Fisher noted, a paradox might be at work. Borrowers repay bank debt, but in the process they destroy money balances and undermine the value of stocks, houses, and land. That increases the real burden of the remaining debt. In his words, “the mass effort to get out of debt sinks us more deeply into debt.”

Sure enough, it has been some years since the worst of the crisis, asset prices have recovered, and American banks have started once more to expand their lending. However, the economy is not firing on all cylinders. Banks today are not providing the same full range of loan facilities as before 2008, while the cost to non-banks of hedging risk (through arranging options and derivatives with banks) is higher than before. Arguably, the increase in capital-asset ratios in the financial sector constitutes a structural impediment to the supply-side of the American economy. 

High bank capital ratios have damaged the American economy on both a cyclical and a structural basis. The solution? Every bank shareholder has a strong interest in ensuring that managements do not take on too much risk relative to the capital entrusted to them. It must be emphasized that the stable macroeconomic performance of the Great Moderation (in the 20 or so years prior to 2007) occurred while banks operated with much lower capital-asset ratios than now. The solution is to scale back untimely and excessive bank capital requirements and restore market discipline on banks and other financial businesses. Let banks spend more time managing risks and less time managing regulators and politicians.

 

This piece was originally published on Forbes.