Capital confusion

Bank capital -- also known as equity -- is not a static asset you "hold" in a vault. Why do megabanks obfuscate about this?

In the late 1980s, regulators from major countries got together to coordinate banking regulation internationally. The idea was to set minimum standards so that, if a country adhered to these standards, the other countries would allow that country’s banks to operate in their territories. In 1988 these negotiations led to the so-called Basel Accord (“Basel I”), named after the city of Basel in Switzerland where the regulators met. Under Basel I, banks were required to have “regulatory capital” equal to at least 8 percent of their business lending. Subsequently, “Basel II,” concluded in 2004, allowed the requirement to be much more finely calibrated to the risks of the different loans and investments. Banks operating under Basel II, which included banks in Europe and U.S. investment banks, found many creative ways to have very high leverage and to evade the requirements by shifting risks to others or hiding them behind flawed risk models or misleading credit ratings.

When the financial crisis began in 2007, the equity of some of the major financial institutions worldwide was 2 or 3 percent of their total assets. The fact that these margins of safety were so thin played a major role in the crisis. For example, without help from the Singapore Sovereign Wealth Fund and from the Swiss government, the Swiss bank UBS would have become insolvent, destroyed by losses from mortgage-backed securities and related derivatives that had been treated as riskless.

In the aftermath of the crisis, regulators set out to strengthen capital regulation. Although the resulting accord, “Basel III,” eliminates some abuses, it fails to address the basic problem that banks can easily game the regulation. Banks’ equity can still be as low as 3 percent of their total assets. It is not clear that anything would have been substantially different in the 2007–2009 crisis had Basel III already been in place.

Nonsense in the debate

According to bankers, higher equity requirements for banks will restrict bank lending and reduce economic growth. They argue that, to have safer banks, we must sacrifice growth. Josef Ackermann, then CEO of Deutsche Bank, claimed in 2009 that higher equity requirements “would restrict [banks’] ability to provide loans to the rest of the economy,” and that “this reduces growth and has negative effects for all.” The Institute of International Finance, a key bank lobbying organization, forecast that the planned Basel III reform would substantially raise interest rates on bank loans in the United States and Europe and lower real growth rates for a number of years. Other bankers and their lobbying organizations echo the same warnings that higher capital requirements would, as JP Morgan Chase CEO Jamie Dimon has put it, “greatly diminish growth.”

These claims and many others made in the debate about capital regulation are invalid—as insubstantial as the emperor’s new clothes in Andersen’s tale. In our book, we show that higher capital requirements do not impose meaningful costs on society. If bankers see them as expensive, the reason is the same as that given by a dye producer who objects to a prohibition on his dumping waste in a river as being expensive because it would cost him $2 million, whereas it would provide a benefit of $20 million for others, for a net benefit of $18 million.

In the debate on bank capital regulation, there are many flawed and muddled arguments. The pervasive confusion of capital — more generally known as "equity" — with reserves is particularly insidious. Consider the statements “Every dollar of capital is one less dollar working in the economy” (Financial Services Roundtable) and “Think of it as an expanded rainy day fund” (Associated Press). These statements would make sense if they referred to banks’ cash reserves, but they are false if applied to bank equity. Capital and reserves are on different sides of the banks’ balance sheets. Capital requirements refer to the banks’ funding, whereas reserve requirements restrict how banks use their funds.

To understand the confusion, consider a mortgage example. If Kate makes a $30,000 down payment on her house, she is using this equity, together with the mortgage loan, to pay for the house. That money is not “set aside” like a cash reserve. The value of the equity will fluctuate as the value of the house changes after the loan is put in place, but at all times the equity is invested in the house. The same is true for corporations. The equity of any corporation—think of Apple or Wal-Mart—just like Kate’s in- vestment in her house, is not sitting idle. The same is also true with regard to the equity of banks, or what the banks call their capital. If a bank holds cash as a reserve, this is part of the bank’s assets. The bank’s depositors and other creditors, as well as the bank’s shareholders that own its equity, have claims that will be paid out of the bank’s assets.

The confusion between equity and reserves is reflected in the language of public debate. In many news reports as well as official writings, banks are said to “hold” or to “set aside” capital as if it were an asset. The word capital itself contributes to the confusion because in other contexts it does refer to assets. For example, when economists say that a firm’s production is capital intensive, they mean that the firm has lots of machines that help it save on labor. In the world of banking and banking regulation, however, capital refers to equity. This equity is held by the investors who fund the bank, its shareholders. To say that the bank “holds capital” is an inappropriate and confusing use of language. The bank is not holding its equity, the part of its balance sheet that represents unborrowed funds; the bank holds loans and other assets funded by equity and debt. Similarly, Apple and Wal-Mart are not said to “hold” their equity.

This is not a silly quibble about words. The language confusion creates mental confusion about what capital does and does not do. This confusion helps bankers, because it creates the false impression that capital is costly and that banks should strive to have as little of it as regulators will allow.

For society, there are in fact significant benefits and essentially no cost from much higher equity requirements. By contrast, reserve requirements have costs, and their benefits in reducing the risks in banking are limited. Unless reserve requirements are so high that banks face virtually no risks, they do not actually address the solvency problem that results from banks’ using borrowed money to make risky investments.

Making false statements that create confusion between capital and reserves is not the only nonsense in the debate. In 2010, when one of us was involved in writing a report to the German government that advocated capital requirements of at least 10 percent of total assets, an industry association objected, saying that the proposal would reduce business lending by 40 percent. Subsequent discussion showed that they had taken the banks’ equity as fixed and concluded that, if capital requirements were to double, lending must be cut in half.

For example, if banks have equity worth €500 billion and this must be 5 percent of their total assets, banks can have assets worth €10 trillion, because they can borrow €9.5 trillion to “leverage” this equity. If the same €500 billion must be 10 percent of the banks’ total assets, according to the reasoning of the industry association, banks would be able to have only €5 trillion in assets because they could borrow only €4.5 trillion using this equity, and presumably their lending would be cut in half.

This argument is misleading, though—another article of the bankers’ new clothes. Banks can grow and invest without borrowing. Banks whose shares are traded on a stock exchange can raise money by issuing additional shares and selling them to investors. If the additional funds are used to make new loans, the higher equity levels will actually allow the banks to lend more rather than less.

Banks that do not have access to a stock exchange can increase their equity by reinvesting their earnings. These banks have at most a problem of transition. After a while, they will have enough equity to support lending at the same levels as before, and they can continue growing by reinvesting their earnings or selling new shares.

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Excerpted from The Bankers’ New Clothes: What’s Wrong with Banking and What to Do About It - New and Expanded Edition © 2024 by Anat Admati and Martin Hellwig. Reprinted by permission of Princeton University Press.

Anat R. Admati is the George G.C. Parker Professor of Finance and Economics at Stanford Graduate School of Business, a senior fellow at Stanford Institute for Economic Policy Research, and a Niskanen Center advisory board member.

Martin Hellwig is director emeritus at the Max Planck Institute for Research on Collective Goods in Bonn.

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Read more:

Can democracy take stock of Wall Street? (Editor’s note)

Bailouts forever - by Anat Admati and Martin Hellwig

The myths that fuel the megabanks - by Thomas Hoenig

Giving power to truth - by Colleen P. Eren

It's time to challenge Wall Street from the supply side - by David Dagan

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