Source: www.federalreserve.gov/newsevents/speech/barr20221201a.htm
In my first speech as Vice Chair for Supervision in September, I said that the Federal Reserve Board would soon engage in a holistic review of capital standards. My argument, then and now, is that our review of regulatory policy must be a periodic feature of bank oversight. Banking and the financial system continuously evolve, and regulation must adapt to address emerging risks. Bank capital is strong, but in doing our review, we should and are being humble about our ability—or that of bank managers—to predict how a future financial crisis might unfold, how losses might be incurred, and what the effect might be on the financial system and our broader economy. That humility, that skepticism, will serve us well in crafting a capital framework that is enduring and effective. It will help make sure that we do not lose the hard-fought gains in resilience over the past decade and that we prepare for the future.
That review is still underway, and I have no firm conclusions to announce today. Rather, I thought it would be helpful at this early stage to offer my views on capital regulation and the role that capital standards play in helping to advance the safety and soundness of banks and the stability of the financial system.1
By “holistic,” I mean not looking only at each of the individual parts of capital standards, but also at how those parts may interact with each other—as well as other regulatory requirements—and what their cumulative effect is on safety and soundness and risks to the financial system. This is not an easy task, because finance is a complex system. And to make the task even harder, we are looking not only at how capital standards are working today, but also how they may work in the future, when conditions are different.
As I mentioned, we are approaching the task with humility—not with the illusion that there is an immutable capital framework to be discovered, but rather, with the awareness that revisions we conceive of today will reflect our current understanding and will inevitably require updating as our understanding evolves.
Why Do Banks Have Capital?
Let me start by explaining why banks have capital. Banks play a critical role in the economy by connecting those seeking to borrow with those seeking to save.2 A bank lends to its customers, including individuals and businesses, based on its assessment of the customer’s creditworthiness. A bank’s depositors benefit from having bank accounts that allow them to easily make payments to others and to maintain a balance of money in a safe and liquid form. A healthy banking sector is central to a healthy economy.
The nature of banking, however, along with the interconnectedness of the financial system, can pose vulnerabilities. Even if a bank is fundamentally sound, it can suddenly be threatened with failure if its customers lose confidence and withdraw deposits.3 This inherent vulnerability can pose risks to the entire economy.
In the 19th and early 20th centuries, before the creation of the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC), banking panics were frequent and costly to the economy.4 Based on this experience—and similar experiences around the globe—many countries employ deposit insurance and other forms of a safety net to protect depositors and banks.5 But offering this protection, shielding depositors and banks from risk, can have the perverse effect of encouraging risk-taking, creating what is called “moral hazard.” Supervision and regulation—including capital regulation—provides a critical counterbalance, to ensure that banks, not the taxpayers, internalize the costs to society of that risk-taking.
The impact of inadequate supervision and regulation was starkly revealed in the Global Financial Crisis, as banks and their functional substitutes in the nonbank sector borrowed too much to fund their operations.6 While nearly all were “adequately capitalized” in theory, many were undercapitalized in practice, since their capital levels did not reflect future losses that would severely weaken their capital positions. And banks lacked appropriate controls and systems to measure and manage their risks.
That crisis also exposed the extent to which banks and broader financial system had become reliant on short-term wholesale funding and prone to destabilizing dynamics.7 The sudden shutdown of short-term wholesale funding posed severe liquidity challenges to large financial intermediaries, both banks and nonbanks, and caused significant dislocations in financial markets.8
The cost to society was enormous, with widespread devastation to households and businesses. Even with an unprecedentedly large response by government, six million individuals and families lost their homes to foreclosure. The crisis brought on the worst and longest recession since the Great Depression. It took six years for employment to recover, during which long-term unemployment ran for long periods at a record high, and more than 10 million people fell into poverty. The crisis left scars on families and businesses that are evident even today, and it was in part driven by imprudent risk taking by banks and nonbank financial institutions. This experience prompted the United States and other jurisdictions to revisit how supervision and regulation, including capital regulation, could have better contained that risk in both the bank and nonbank sectors. That is why capital levels today are strong. While we have learned from and adapted to the lessons from the Global Financial Crisis, this experience underscores the need for humility and continued vigilance about the risks we may not fully appreciate today.
What Bank Capital Is and Isn’t
Capital regulation—requiring a bank to operate with what is deemed to be an adequate level of equity based on its asset size and its risks—is a useful tool to strengthen the incentives for banks to lend safely and prudently.
First, I’ll begin with what capital is—essentially shareholder equity in the bank. People sometimes use the shorthand of banks “holding capital” when speaking of capital requirements; however, it’s helpful to remember that capital is not an asset to be held, reserves to be set aside, or money in a vault; rather, it is the way, along with debt, that banks fund loans and other assets. Without adequate capital, banks can’t lend. Higher levels of capital mean that a bank’s managers and shareholders have more “skin in the game”—and have incentives to prudently manage their risks—because they bear more of the risk of the bank’s activities.
Next, let me speak to how capital and debt work together to fund a firm’s operations. In theory, companies should be indifferent to the mix of equity and debt they use to fund themselves, since the creditors of a safer firm will lend to it at lower rates and shareholders of a safer firm will accept a lower return on their investment.9 That may not fully hold for banks because insured depositors are made risk-insensitive through deposit insurance and other creditors may provide lower cost funding if they believe the government may bail out banks in distress.10 Forcing banks to fund more of their activities with equity, instead of debt, could raise the private costs of funding to the bank, and cause banks to pass those higher costs of credit to consumers. These considerations must be balanced against the public benefits of higher capital.
Empirical research supports the social benefits of strong capital requirements at banks, particularly when economic conditions weaken. While poorly capitalized banks may be forced to shrink during bad times, better capitalized banks have the capacity to support the economy by continuing to lend to households and businesses through stressful conditions.11 And to the extent bank capital reduces the frequency or severity of financial crises, the public is much better off with strong capital.12
Last, the highest standards should apply to the highest risk firms. Larger, more complex banks pose the greatest risk and impose greater costs on society when they fail. Higher capital requirements help to ensure that larger, more complex banks internalize this greater risk and counterbalance the greater costs to society by making these firms more resilient. Further, matching higher capital standards with higher risk appropriately limits the regulatory burden on smaller, less complex banks whose activities pose less risk to the financial system. This helps to promote a diverse banking sector that provides consumers greater choice and access to banking services.
h/t Dismal-Jellyfish