Bankers typically present capital requirements as a sort of zero-sum game, or worse. If banks have more capital — that is, finance their activities with more of their own shareholders’ money, or equity, as opposed to debt — they’ll be less likely to go bankrupt and exacerbate crises. But, the logic goes, capital is expensive: If they can’t use as much cheap, borrowed money, banks will have to charge more for loans, an outcome that could hobble the economy and make us all poorer.
That logic, though, contradicts an insight that financial economists Franco Modigliani and Merton Miller had more than 50 years ago: Any firm’s financing costs shouldn’t depend on the mix of debt and equity it chooses. Shareholders demand high returns on bank equity in part because banks’ heavy borrowing subjects them to a lot of risk. Many banks typically borrow $30 or more for every $1 their shareholders put in, so a mere 3% drop in the value of their assets can wipe out the shareholders’ investment completely. If banks borrowed less, equity would probably be cheaper. The only reason debt remains a better deal is that governments subsidize it through creditor bailouts and tax breaks on interest.
This new paper estimates costs and benefits of higher capital and finds much higher benefits:
The Bank of England economists estimate, for example, that a permanent one-percentage-point reduction in the probability of banking crises is worth more than half an entire year’s economic output. By contrast, permanently doubling banks’ capital ratios would add only about 0.06 percentage point to companies’ financing costs, taking a long-term bite out of the economy equivalent to about 6% of one year’s output.
The upshot: If one assumes that really bad crises tend to happen every few decades or so, the most beneficial capital level would be 52% of assets, weighted according to their riskiness. Even if one assumes the future holds only mediocre crises, the optimal capital ratio would be about 19%. That compares to a 7% requirement big global banks must meet by 2019 under new rules drawn up in Basel last year.
Some really stiff proposals coming from UK….