Should The G-20 Require Banks To Increase Reserves?

The G-20 meets this week in Pittsburgh. One of the central topics of discussion will be financial regulation. The global financial crisis has begun to wane, but most nations are still feeling the sting caused by the meltdown. One topic will likely be banker compensation. Another might be bank capital reserve requirements. The New York Times reports that the European Shadow Financial Regulatory Committee believes the G-20 should increase capital requirements. I don't see how this could do much harm.

I've written before about several positive outcomes that this might have. But I haven't considered the negative criticism of higher capital requirements: banks will be forced to be more conservative. That might seem like a good thing at a time like the present, but it isn't always. If banks are forced to hold more capital, that implies that they will be able to lend less and growth might be needlessly stunted.

I'd have a few responses to this. The most obvious is that credit was entirely too easy before the financial crisis. That, after all, was one of its central causes. If banks hadn't had so much freed up capital to throw at anyone with a pulse to buy a home, then there would not have been a bubble, or at least not a bubble the size of the one we got.

Of course, higher capital reserves also mean lower profits for banks in good times. I would argue that's a small price to pay for more stability in bad times. In a vacuum that could cause a talent drain: if stricter requirements were put in place in only a handful of nations, some the brightest minds might flee to foreign banks lower capital requirements for higher profits. But the G-20 isn't a vacuum. If a global agreement were struck, then talent would mostly stay put, as there wouldn't be any greener pastures.

Finally, higher reserve requirements don't have the same affect on a bank's ability to lend as they once did. 50 years ago, it was very important for reserve requirements to be relatively low, because banks used freed up capital to make loans -- arguably the most important function of a bank. These days, however, we have (or had) a robust securitization market in place for funding. Banks can securitize all sorts of loans and sell the resulting bonds to investors in order to get fresh capital to make new loans. Obviously, securitization is still reeling from the crisis, but it eventually will return to pre-bubble issuance levels. The only kinds of loans that might not make it back into the securitization market indefinitely would be the really ugly ones. I'd argue that we don't want those securitized, or even funded with bank capital, too often anyway.

I don't believe that capital requirements being too low were the main cause of the financial crisis, but it was certainly a contributing factor. And when the music stopped, the fact that too few banks had enough capital in place to cover their losses certainly exacerbated the crisis. I'm not sure what the right increase in capital requirements would be; I will leave that to regulators with more experience in such details. But a modest increase -- without getting too carried away -- seems pretty sensible to me.