Here Come Higher Capital Requirements

About a week ago, I wrote about how big banks are beginning to ramp their leverage back up again. In it, I noted my surprise that lawmakers hadn't chosen lowering leverage as a major goal for financial regulation. According to complementary articles in the New York Times and Wall Street Journal today, both U.S. and British governments now have higher capital requirements in their crosshairs after all. I find this strategy sensible for several reasons.

Here are blurbs from each of these articles, explaining what's going on. First, the Obama administration's plan, according to the Times:

The thrust of the plan is to have banks, particularly those deemed too big to fail, maintain larger capital cushions -- a move bankers have traditionally opposed because it eats into their profits. The Treasury secretary, Timothy F. Geithner, is expected to outline the administration's proposals Thursday in a letter to the finance ministers of the Group of 20 industrial and emerging nations, who are scheduled to meet in London this week.

And Britain's plan, from the WSJ:

Under a proposal now being debated within the agency, banks in the U.K. that trade in the most risky securities also may face as much as a fivefold increase in the amount of capital the U.K. requires to cover losses on trading books, said Adair Turner, chairman of the U.K.'s Financial Services Authority. This would be much more than some bankers had been expecting.

Mr. Turner also gave his strongest indication yet that banks large enough to threaten the stability of the financial system can expect higher capital ratios, a controversial idea that the FSA and other global regulators have been considering.

Clearly, U.S. and British regulators are signing in harmony. The purpose of these capital cushions would be to guard against unforeseen losses or a lack of liquidity that could break the banks. Prior to the crisis, banks did not have the capital base necessary to withstand the catastrophic financial strain that sudden losses and the credit crunch caused. That's where the bailouts came in.

On a fundamental level, I see this as a logical and direct response to what really caused the financial crisis. If banks had less leverage and more capital, they would have been able to more easily withstand losses and liquidity problems. They didn't, and bad things happened. But there are also two particularly nice consequences that would stem from forcing big banks, in particular, to have even bigger capital cushions than smaller banks, which both plans described above reportedly intend.

First, it would help to reduce the competitive advantage of firms deemed too big to fail. Currently, such firms should enjoy a significant edge over smaller competitors, because their lenders and investors know that the government will prop them up no matter what, given the systemic risk their failure would pose to the financial markets. As a result, those banks will enjoy lower costs of capital and better investment than their smaller rivals who the government won't save.

But if you require these big banks to have larger capital cushions, then that should neutralize some of that advantage caused by lower borrowing costs and greater investment. Since they need to hold more capital than the smaller banks, big banks' return on capital will be necessarily lower than it would have been otherwise. This is good for competition and market efficiency.

Second, this might also be a partial solution to the bonus problem. It's the big banks who are generally responsible for those large Wall Street bonuses that have recently gotten so much attention. If big banks are required to have more capital, however, their profits will be lower. As a result, the bonuses they are able to pay out to employees will also be necessarily lower.

Of course, there is a sort of obvious, looming criticism to this plan that points to a much simpler solution: it creates a more complex regulatory scheme when the easier answer might have been to just allow the market to work. In a free market, where all banks are susceptible to failure, you would not need higher capital requirements set by governments. Investors and lenders would naturally demand bigger capital cushions, or else they would not be comfortable putting money up to support the banks' business. That's the beauty of the free market.

Part of the reason that things didn't turn out this way during the financial crisis was that lenders and investors wrongly believed that these institutions were too big to fail, so their low capital requirements were sufficient. Clearly, the financial community had learned otherwise, until governments decided to step in and re-define too big to fail as a category, rather than a flawed market assumption. But so long as the government insists on propping up these firms, higher capital requirements seem a step in the right direction.