Minneapolis Fed stokes debate over bank capital, safety

Less obvious than breaking up the big banks but nearly as abhorrent to the financial industry is the idea of forcing them to back up their business with more equity and less debt.

Steeper capital requirements are one of the ideas floated by Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, as part of a yearlong push to end the "too-big-to-fail" phenomenon.

Kashkari's sweeping initiative has set bankers' hair afire across the country and prompted a wave of criticism. Just last week, former Treasury Secretary Larry Summers called the whole thing "blatantly political." But the Minneapolis Fed is moving forward, with former Fed Chairman Ben Bernanke slated to visit Minneapolis for a second forum on the topic May 16.

A question that came up at Monday's inaugural forum and will come up all year is whether large banks have enough equity capital to be safe, and whether forcing them to issue more equity rather than debt is a useful way to prevent another finance industry collapse and spare taxpayers another bailout.

Banks don't just collect deposits and lend the money to other customers. They borrow money to lend it out — a lot more than they used to. American banks in the 1800s often held capital equal to 50 percent of assets, meaning they could absorb huge losses without becoming insolvent and needing a bailout.

Equity capital at banks — the shareholders' investment — shrank over the years and by the time the financial crisis arrived in 2007, the 10 largest banks in the country had equity capital equal to only 2.8 percent of their assets, according to Thomas Hoenig, vice chairman of the Federal Deposit Insurance Corp.

Lacking a cushion of equity when the drop in home prices triggered the financial crisis, several of the nation's largest financial institutions either collapsed or had to be bailed out.

Since then, bank capital positions have improved. The Dodd-Frank financial reform law encouraged higher capital ratios. The Basel Accords on international banking also imposed new, complex capital standards on banks. These reforms are having an effect, as bank capital has doubled or tripled in the past few years.

Now, the eight globally systemically important banks in the U.S. have an average capital ratio of 5.73 percent, according to Hoenig. Just under 6 percent of assets is still not enough capital, he said. It means that for every dollar loaned, 94 cents is financed by debt.

"Banks with at least 10 percent equity capital have lower rates of failure and stable rates of lending over the course of an economic cycle," Hoenig said on Wednesday in Virginia. "In addition, and importantly, a majority of commercial banks already meet the 10 percent equity capital level."

Anat Admati, a Stanford economist, led off Monday's symposium on ending too-big-to-fail in Minneapolis, arguing large banks remain severely undercapitalized, at taxpayer expense.

"We subsidize recklessness in banking," she said.

Admati argues large banks should issue equity at least equal to 30 percent of their assets, a proposal that elicits eye-rolling among bankers. More equity means less lending, and higher costs to banks and their customers. Deborah Lucas, a finance professor at MIT's Sloan School of Management who responded to Admati, said she believes bankers when they say these things.

"They further, actually say, in fact we are heavily regulated," Lucas said. "We are more prudent, for better or worse, than we ever have been."

The cost to bankers of higher equity capital — and the search for a balance between safety and risk — is at the heart of the argument.

"The more capital that you have on the balance sheet, the less lending you can do," said Thane Bublitz, a bank analyst for Thrivent Financial.

Different banks lend money in different ways, he said, and so their risks are different. To force them all to hold the same equity capital relative to assets doesn't make sense. And he believes banks today are largely safe. "In my opinion the banks right now are well enough capitalized to absorb losses in a downturn," Bublitz said.

Admati was not alone, however, in believing the largest banks are not well-capitalized enough.

"Even if you're very broad-minded on this, even if you take a different course, you have to believe the current amount is insufficient," said Adam Posen, an economist at the Peterson Institute, a private research institution that specializes in international economic policy.

Posen argued that current capital requirements are too complicated, and won't work when several banks are under stress at once.

"It's too clever by half," he said. "If you're over-engineering something, it's only going to respond in a specific state of affairs."

V. V. Chari, a University of Minnesota economist, isn't persuaded that "command and control" blanket capital requirements are the right course. Some banks will fail in a capitalist economy, and he prefers a mechanism whereby debt issued by banks can be converted to equity in a crisis, forcing creditors to take losses instead of turning to government for a bailout. He grants that lending would suffer if capital requirements rose, but also regards the banks' protestations with skepticism.

"I think it's a legitimate concern, but they have a self-interest in claiming too much," Chari said. "To the extent that they can rely on a taxpayer bailout anyway, they have an incentive to keep capital requirements as low as possible."

Adam Belz • 612-673-4405 Twitter: @adambelz