Banking Industry Overly Focused on Capital

Years ago, when I was still a banker, a good customer said, "I have no idea how to evaluate creditworthiness, but my guess is that a big down payment eliminates a lot of potential problems." My customer was right, but his analysis was narrow and a bit crude. I am reminded of that conversation by the current seemingly narrow emphasis on increasing minimal capital requirements as a singular method of preventing a repeat of the recent banking crisis.

Make no mistake, a strong capital position and minimum capital requirements are important components of a strong and well-regulated banking industry. But an emphasis on capital to the exclusion of all else is, at best, misleading and, at worst, harmful to the banking business model. Capital requirements should complement risk management, which also includes a focus on liquidity and operational risk, and a strong supervisory framework.

The commercial bank business model is predicated on the appropriate use of leverage. The core of the banking industry's role as a financial intermediary, which has become more complex over time, is to convert demand and savings deposits into productive lending. Minimum capital requirements significantly impact that role. The greater the capital requirement, the less funds are available to lend.

Also, generating an appropriate return on equity for a bank with a 15% capital/assets ratio requires a much larger interest rate margin than generating the same return on a 10% ratio – and almost certainly requires greater risk in the loan portfolio. By contrast, an overly leveraged institution (and therefore one with a very low capital/assets ratio) does not have the loss absorption capacity to handle anything other than totally risk-free assets. The ideal capital position (also known as the optimal economic capital position) is one that provides an appropriate buffer against losses, but allows for an acceptable market return on the institution's invested capital.

The current Washington-based focus on enhancing capital does not seem to recognize that basic concept. We hear and read that greatly enhanced capital requirements would have prevented the last banking crisis and will ensure that we will not have another. Perhaps the most dramatic example of that line of thought was the recent introduction of the Brown-Vitter bill that would potentially raise capital levels to 15% for banks that had achieved an asset size above $500 billion.

In unveiling the bill, it was not clear if Sens. Sherrod Brown, D-Ohio, and David Vitter, R-La., two members of the Senate Banking Committee, were addressing a perceived capital weakness, or if the intent was to deter banks from achieving an asset accumulation of that size.

The surprise to me was not the introduction of the bill, but rather the response it received from seemingly informed sources. A Washington Post editorial welcomed the bill and postulated that banker opposition was primarily due to the inevitable reduction of return on equity and the resulting impact on executive pay. No mention was made about how more than doubling capital requirements – to a level unsupported by analysis – would impact lending, and therefore the entire U.S. economy. A similar reaction came from an op-ed in the New York Times, which went so far as to suggest that perhaps the bill did not go far enough.

While not imposing the tough capital requirements included in the bill before Congress, the recent Basel III capital rules adopted by the federal banking agencies perpetuate this narrow reliance on capital to prevent the next financial crisis. The rule imposes a host of leverage and capital ratios and buffers.

While not all of the measures apply to all banks, even smaller banking organizations will face new requirements. Moreover, under a related proposal, the largest banks would be subject to a leverage ratio that is twice the Basel III minimum of 3%. Prompt corrective action rules would require a 6% standard in order to be eligible to conduct a full range of activities without supervisory restriction.

Missing from the discussion is a review of the impact capital levels have had on bank failures in recent years. The Basel III final rule discusses impact in terms of studies of the economic benefits and costs of stronger capital requirements, but these studies do not address the efficacy of capital in preventing bank failures. However, the bank regulatory agencies have done studies of past bank failures in an effort to benefit from the lessons taught by those experiences.

At a recent presentation, Martin Gruenberg, chairman of the Federal Deposit Insurance Corp., cited a study conducted by the inspector general of his agency to identify the "key attributes" of institutions that failed. The IG found three common factors among banks of all sizes that failed during the recent crisis:  rapid growth; concentrations of high-risk assets; and reliance on volatile brokered deposits. Relative capital/assets ratios were not cited as one of the three major contributing factors.

An earlier FDIC study, which reviewed bank failures from the 1980s through the mid-1990s, provided a similar analysis. The study included an entire chapter on the resolution of Continental Illinois Bank in 1984.  At the time of the resolution, Continental Illinois was the nation's seventh-largest bank, making this the largest bank resolution in history. In reviewing the factors contributing to the bank's demise, the study called attention to the dramatic increase in commercial and industrial loans relative to the bank's peers. It also noted the very aggressive pricing on those loans, which indicated willingness by bank management to use a below-market pricing strategy in order to build volume at the expense of maintaining interest margins. In evaluating Continental's capital/assets ratio for that period, a comparison showed that capital levels were consistent with peers at the time. Interestingly, none of the bank's peers had capital/asset ratios in excess of 5%.

The intent of this analysis is not to discount the role of capital adequacy as an element of bank supervision. Rather, in reviewing the history of bank failures and subsequent resolutions, low bank capital ratios have not been a primary cause of bank failures. Bank regulators and policymakers on Capitol Hill should balance capital adequacy with other elements of a strong supervisory environment.

Mark W. Olson is co-chair of Treliant Risk Advisors LLC and can be reached at molson@treliant.com. His former positions include Federal Reserve Board governor, chairman of the Public Company Accounting Oversight Board, chairman of the American Bankers Association and bank president and CEO.