Making Capital Rules Work

Let us give credit where credit is due. The G-20 process, and the new Financial Stability Board working behind it, has produced a useful response to the financial crisis. We are coming out of the Pittsburgh Summit with an international agreement to significantly increase capital requirements for banks, and in fact for all systemically important financial institutions. This is a necessary improvement in the stability of financial systems going forward.

Rules, however, are only as good as their enforcement. To get lasting benefits from this change in financial structures, we need supervisors to strictly implement the rules. This will not be easy. There are political, international, and institutional forces that will immediately work against enforcing the rules. The G-20 needs to bind the hands of its own governments to keep this from happening-and the European Union should lead the way in making this happen, given its successful experiences with such self-restraint through mutual agreement.

The basic logic of raising and tightening capital standards for banks is largely unassailable. We know banks (and other financial institutions) took excessive risks, and we know they had too little reserves on hand to survive when the risks went bad. Requiring them to hold more capital reduces both problems. If banks have more of their own (i.e., shareholders' and top managers') capital at stake, they will be more careful in their investing; if banks have greater reserves on hand, they will be less likely to require bailing out by the taxpayer. Adherence to these capital standards can be monitored relatively easily. So what is the problem?

The first difficulty is political in each country on its own. More capital for banks means less leverage, and less leverage means tighter credit. Tighter credit in turn means slower-although more sustainable and steady-economic growth. Some interest groups will face borrowing constraints where there were none, and they will complain. The process of capital raising, and thus of credit tightening, will rightly be more extreme for banking systems that lent too much and had the subsequent busts, but everyone will be affected. What is good for the system as a whole and a necessary corrective to past excesses will be very unpopular. And this will not be just transitional as people get used to the new regime. There will be recurrent calls for special lending programs for ostensibly worthy purposes, like small business financing or home ownership, which would erode the standards if accommodated.

The second difficulty is international. By now it should be evident to all that a country having "global players" in international banking is a mixed blessing at best. Certainly, it is no more productive and no less fraught with danger than any other picking winners. Yet, both ideology and influence drive calls for governments to protect and promote national champions in financial services. With that goal in mind, governments have an incentive to lighten the burden from capital requirements on their own banks. Just as under the failed Basel II regime, governments will thus argue for recognition of "national differences" in banking systems, or unilaterally interpret the rules to their leading banks' advantage-and thus, also eroding the capital standards.

Finally, the greatest difficulty is institutional. Even governments that advocate increased capital standards with the best of motivations mostly still want to retain discretion for officials in how to implement those standards. The US Treasury in particular displays this duality by pushing for increased regulation, but also wanting a "systemic risk board" to make case-by-case assessments, or leaving room for government judgment in deciding how to adjust capital requirements for the largest banks. In short, the United States and some other governments want to retain discretion over their policymaking rather than precommitting to stricter rules.

This discretion for governments could defeat the purpose of increased capital standards. At a minimum, it makes it difficult for today's governments to credibly commit to strict enforcement in the future since their successors will have room for play, and it will incentivize banks to continually lobby for easier interpretations. At worst, it adds to confusion and uncertainty about the impact of the capital standards from the start, and is an admission that there is insufficient political will to be truly tough on the banking system.

Stricter capital standards can be successfully enforced, despite these difficulties, if the G-20 governments instead commit to a rules-based approach rather than maintaining discretion. Yes, such a commitment would entail some cost in flexibility, and probably result in greater initial contraction of credit as the financial system adjusts. Those costs are dwarfed, however, by the results of the alternative approach we have already seen: politically influenced lending programs off-balance sheet, international races to the bottom for corporate advantage, and no credible deterrence of moral hazard. The G-20 should make a very blunt, transparent, simple, and yes inflexible rule about how much capital all financial institutions need, of what specific type, and enforce it at an international level. Anything less will probably be gotten around in short order.