Large banks have grown and become more involved in market-based activities since the late 1990s. This column presents evidence that large banks receive too-big-to-fail subsidies and create systemic risk, whereas economies of scale in banking are modest. Hence, some large banks may be ‘too large’ from a social perspective. Since the optimal bank size is unknown, the best policies are capital surcharges and better bank resolution and governance.
Large banks have grown significantly in size and become more involved in market-based activities since the late 1990s. Figure 1 shows how the balance-sheet size of the world’s largest banks increased two- to four-fold in the ten years prior to the crisis. Figure 2 illustrates how banks shifted from traditional lending towards market-oriented activities.
The ‘deadly embrace’ between banks and their government has strengthened with the EZ Crisis. This column argues that this has mostly been consequence rather than a cause of the Crisis. Moreover, adverse bank-sovereign negative feedback depends on the economy-wide effects of the sovereign risk, not just the banks’ direct exposure. Loosening the embrace requires sound public finances and well-capitalized, well-supervised banks – including the banking union project.
Sovereign debtors and their national banking systems are closely linked through a range of direct and indirect channels. These include banks’ claims on sovereigns, semi-automatic links between sovereign and bank credit ratings, public backstops, collateral in banks’ operations, and the effects of fiscal distress on the overall economy – and thus the quality of bank loans (CGFS 2011, Bank of Italy 2013a).
Estimating the impact of changes in aggregate bank capital requirements during an upswing
Joseph Noss, Priscilla Toffano06 April 2014
The impact of tighter regulatory capital requirements during an economic upswing is a key question in macroprudential policy. This column discusses research suggesting that an increase of 15 basis points in aggregate capital ratios of banks operating in the UK is associated with a median reduction of around 1.4% in the level of lending after 16 quarters. The impact on quarterly GDP growth is statistically insignificant, a result that is consistent with firms substituting away from bank credit and towards that supplied via bond markets.
The recent financial crisis and economic contraction that followed highlighted the crucial role that banks play in facilitating the extension of credit and enabling economic growth. This underlies the economic rationale for imposing regulations on the banking industry, including minimum capital requirements designed to mitigate risks banks would not otherwise account for in their behaviour.
Charles Calomiris talks to Romesh Vaitilingam about his recent book, co-authored with Stephen Haber, ‘Fragile by Design: The Political Origins of Banking Crises and Scarce Credit’. They discuss how politics inevitably intrudes into bank regulation and why banking systems are unstable in some countries but not in others. Calomiris also presents his analysis of the political and banking history of the UK and how the well-being of banking systems depends on complex bargains and coalitions between politicians, bankers and other stakeholders. The interview was recorded in London in February 2014.
Viral Acharya talks to Viv Davies about his recent work with Sascha Steffen that, using publicly available data and a series of shortfall measures, estimates the capital shortfalls of EZ banks that will be stress-tested under the proposed Asset Quality Review. They also discuss the difference in accounting rules between US and EZ banks and the future potential for banking union in the Eurozone. The interview was recorded by phone on 25 February 2014.
Falling short of expectations? Stress-testing the European banking system
Viral Acharya, Sascha Steffen17 January 2014
The Single Supervisory Mechanism – a key pillar of the Eurozone banking union – will transfer supervision of Europe’s largest banks to the ECB. Before taking over this role, the ECB will conduct an Asset Quality Review to identify these banks’ capital shortfalls. This column discusses recent estimates of these shortfalls based on publicly available data. Estimates such as these can defend against political efforts to blunt the AQR’s effectiveness. The results suggest that many banks’ capital needs can be met with common equity issuance and bail-ins, but that public backstops might still be necessary in some cases.
The Eurozone is mired in a recession. In 2013, the GDP of the 17 Eurozone countries fell by an average of 0.5%, and the outlook for 2014 shows considerable risks across the region. To stabilise the common currency area and its (partly insolvent) financial system, a Eurozone banking union is being established. An important part of the banking union is the Single Supervisory Mechanism, which will transfer the oversight of Europe’s largest banks to the ECB (Beck 2013).
Bank capital requirements: Risk weights you cannot trust and the implications for Basel III
Jens Hagendorff, Francesco Vallascas16 December 2013
Recent research shows that capital requirements are only loosely related to a market measure of bank portfolio risk. Changes introduced under Basel II meant that banks with the riskiest portfolios were particularly likely to hold insufficient capital. Banks that relied on government support during the crisis appeared to be well-capitalised beforehand, suggesting they engaged in capital arbitrage. Until the regulatory concept of risk better reflects actual risk, the proposed increases in risk-weighted capital requirements under Basel III will have little effect.
One of the primary purposes of bank capital is to absorb losses. Where bank capital holdings are insufficient to absorb losses, banks will either fail or – if bank failure is deemed too costly for the economy – be bailed out. In practice, banks frequently receive public funds where capital holdings are insufficient to cover losses in order to prevent bank failure. Whether or not bank capital holdings are sufficient and in line with the risk of bank portfolios is therefore an important question that is hotly debated among policymakers and in the press.
Is a 25% bank equity requirement really a no-brainer?
Charles W Calomiris28 November 2013
There is widespread agreement that government protection of banks contributed to the financial crisis, leading to proposals to require banks to finance a larger share of their portfolios with equity instead of debt – thus forcing shareholders to absorb losses instead of taxpayers. This column argues that equity ratios relative to asset risk are what matter, not equity ratios per se. Although higher equity requirements for banks may be desirable, the costs of reduced loan supply should be taken into account.
Professor Allan Meltzer famously quipped that “capitalism without failure is like religion without sin”. If some firms are protected from failure when they cannot pay their bills, then competition is skewed to favour inefficient, protected firms. Banks whose debts are guaranteed by the state receive an unfair advantage that enables them to allocate funds inefficiently, recklessly pursue risks at the expense of taxpayers, and waste resources that would be better used by firms operating without such protection.