Capital Requirements For Banks Are Needed But Costly—Only Limited Increases Are Called For

Washington—A new book published by the Peterson Institute for International Economics argues banking regulations after the financial crisis have made banking systems safer, but overall capital requirements under Basel III remain inadequate. In The Right Balance for Banks: Theory and Evidence on Optimal Capital Requirements, William R. Cline, a renowned expert on financial markets and senior fellow at the Peterson Institute, argues that the appropriate level of capital for banks to hold for optimal tradeoff between economic growth and financial stability is 7 to 8 percent of total assets. Unduly high requirements for equity capital in banks could cause higher lending rates, less formation of capital stock throughout the economy, and therefore lower productive capacity, he concludes.

Cline’s study, one of several analyses of financial stability published by PIIE since the crisis of 2008–09, reviews the extensive literature on banking crises, regulations, and their impact on capital formation and economic growth. It looks indepth at the multilateral voluntary framework on bank capital adequacy known as Basel III, established in 2010–11, which raised the amount of equity capital that banks must hold. The Basel III rules only require the largest banks to hold 9.5 percent of risk-weighted assets in equity capital. Cline calculates instead that equity capital should be 12 to 14 percent of risk-weighted assets, corresponding to 7 to 8 percent of total assets. While an increase, this assessment is in contrast to some academics’ calls for far higher bank capital, ranging from 15 to 25 percent of total assets.

The Right Balance for Banks makes a major contribution to the policy debate by providing a rigorous, replicable, and transparent calculation of the optimal capital requirement for banks. It first considers whether and how much banks would have to raise lending rates if forced to hold more capital. Cline tests an oft-invoked theory from financial economics (Modigliani-Miller) that implies there would be no cost to raising capital because investors would be satisfied with lower returns thanks to lower leverage and lesser risk. Cline instead finds that, in practice, slightly less than half of this risk-reduction offset would occur. He then applies a consensus estimate of the influence of bank capital on the risk of banking crises, combined with well-established relationships between output and capital stock, to calculate the point at which higher costs to the economy from higher bank capital requirements are just offset by lower expected crisis damage.

Cline’s book also discusses related questions such as whether “too big to fail” causes large banks to take excessive risk and whether there are important economies of scale in banking. He questions recent studies that argue the financial sector is curbing growth because it has become excessively large as confusing correlation with causation.

“After the Great Recession, a lot of economists understandably argued that excessive finance is dangerous and that we have to at least double bank capital levels, but did so without rigorously and quantitively assessing the potential cost to the economy of doing so.” said Adam S. Posen, PIIE president. “Bill acutely realizes that there is an economic cost of over-capitalization and curbing bank credit. His analysis derives and estimates an optimal level of financial regulation that he argues is sufficient to safeguard the global financial system from another financial crisis, without unnecessary brakes on economic growth.”

The Right Balance for Banks: Theory and Evidence on Optimal Capital Requirements
William R. Cline
ISBN paper 978-0-88132-721-2
June 2017 • 242 pp. • $23.95