Economics

Why Banks Could Learn to Love Tougher Regulations

A new study finds that higher capital requirements could leave banks with more money to lend.

January 21, 2021

| by Edmund L. Andrews

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A customer uses an ATM at a Bank of America branch. Credit: REUTERS/Brian Snyder

Higher capital requirements appear to make banks more prudent and thus contribute to lower economic volatility.| REUTERS/Brian Snyder

Among bank executives, it’s almost an article of faith: If regulators force them to reserve more capital against potential losses, bank lending will decline, businesses will struggle, and economic growth will slow.

It seems intuitive, and some studies have backed up the idea. If banks are required to keep more money in reserve, conventional wisdom contends, they will have less money to lend to consumers for buying cars and homes or to companies that want to grow. That will put a brake on economic activity, and everyone will end up poorer.

But a new study by Juliane Begenau, assistant professor of finance at Stanford Graduate School of Business, turns the conventional wisdom on its head. In fact, Begenau estimates, higher capital requirements in the United States would actually lead to more bank lending, more consumer spending, and less economic volatility.

“What we find is that today’s capital requirements are too low,” says Begenau. “The optimal level, from an economic viewpoint, would actually be about 50% higher.”

Startling Conclusion

It’s a startling conclusion, and Begenau backs up her argument with a mountain of banking and economic data from 1999 through 2016 — a period that includes the financial collapse of 2008 and the higher capital requirements that U.S. regulators imposed in the aftermath.

So why is the industry wisdom wrong? The main reason, Begenau argues, is that most prior studies are based on overly narrow economic models. If you compare a bank with lower capital requirements to one with higher requirements, the one with lower requirements will have more money to lend.

Supporters of higher capital requirements have long defended them on the argument that they prevent reckless risk-taking that could lead to systemic bank failures and major economic disruption — as occurred during the mortgage meltdown in 2008.

But Begenau makes a very different argument. She built and tested an economic model that looked at how higher capital requirements would affect bank deposits and banks’ cost of capital.

Lowering Capital Costs

The surprising result, she found, is that higher capital requirements can actually increase bank lending because they reduce the cost of their capital.

While higher capital reduces the share of a bank’s assets that can be used for lending, it also reduces the bank’s appetite for attracting deposits. That’s because deposits are essentially loans to a bank, and higher capital requirements reduce how much a bank can borrow.

That creates a surprising new dynamic, Begenau writes, because consumers still want to keep money in bank accounts. Consumers get what’s called a “convenience yield” from their accounts, regardless of capital requirements. But because banks can’t borrow as much, and therefore don’t need to attract as many deposits, they can offer customers lower interest rates to attract the deposits they need.

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What we find is that today’s capital requirements are too low. The optimal level, from an economic viewpoint, would actually be about 50% higher.
Attribution
Juliane Begenau

At the end of the day, Begenau says, the lower cost of capital allows banks to lend more than they would have before. “When bank deposits become scarce, households are willing to hold them even if they pay a low interest rate,” Begenau writes. “This lowers banks’ cost of capital, leading to more — not less — lending in the economy.”

To test her model, Begenau ran 1,000 computer simulations against a massive amount of historical data on U.S. banking activity — deposit interest rates, assets, lending volumes, and much else — as well as on U.S. economic activity. The data included the times before and after the 2008 financial collapse, a crisis that prompted bank regulators to raise capital requirements to protect against a repeat calamity.

Contrary to the conventional wisdom, Begenau found that higher capital requirements led to a lower cost of capital, more bank lending, more personal consumption, and higher bank profitability. At the same time, the higher requirements appeared to make banks more prudent and thus contributed to lower economic volatility.

More Skin in the Game

At the moment, American banks must have capital reserves equal to 8% of their risk-based assets. Begenau estimates that the optimal capital requirement would be about 12% — or 50% higher than current requirements.

At that level, the study estimates, the average cost of capital for banks would drop to 0.39% from 1.23%. Because that would make lending more profitable, overall bank lending would increase by 2.35%.

On the macroeconomic level, Begenau finds that the higher rates would feed through to increases in personal consumption and higher production from non-financial firms.

Meanwhile, Begenau also finds that financial and economic volatility would go down. Higher capital requirements would require banks to have more of their own skin in the game, which gives them incentive to monitor their loans more carefully and take fewer bad risks. Likewise, they would have less incentive to rely on government protections — like subsidized deposit insurance — if things go wrong. As a result, banks would become more stable at the same time they earn higher returns.

“What people have been getting wrong is to base studies on a partial equilibrium argument — if you shock one set of banks with a higher capital requirement and compare them to banks with a lower requirement, the first group will lower its lending,” Begenau says. “But you have to look at this as a general equilibrium model. You have to look at how all the elements affect each other.”

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