The Clearing House has a new study complaining about the idea that the world’s biggest banks — the Too Big To Fail institutions — should have higher levels of capital than other banks. (The study is meant to be here, but the website isn’t working very well, so I’ve mirrored it here.pdf.) The main conclusion is that “if the Basel Committee’s G-SIB capital surcharge is implemented in the U.S., these banks would have to either increase the borrowing costs to their customers by 60 basis points” — an outcome so self-evidently horrific that the study doesn’t even bother to explain how harmful it would be.
But of course a closer look at the study shows that borrowing costs wouldn’t actually need to rise at all. Here’s the key headline in the presentation:
NIM here, is Net Interest Margin, which is then used to compute borrowing costs. And “NIX ratio” is non-interest expenses, known to many as “bankers’ bonuses”.
The calculations here are not mathematically unconvincing. According to The Clearing House, the cost of bank equity will go down under the new regime — by about 70 basis points. That won’t make up for the hit to shareholders from being less leveraged.
So yes, it’s entirely possible that there is indeed a non-negligible cost to implementing this surcharge. That cost is going to have to be borne by three different groups: borrowers, bankers, and bank shareholders.
But if you look at the report, it’s predicated on the idea that shareholders don’t bear any of the cost at all all: we have to “maintain shareholder returns”, for some unknown reason. This is silly, for reasons convincingly explained by Martin Wolf — the returns that banks are offering to their shareholders are far too high. Back in the '50s and '60s, banks had a return on equity around 7%; now they require more than double that. There’s no reason why we shouldn’t go back to the old returns.
If banks’ return on equity fell from about 15% to about 7%, then there wouldn’t be any increase at all in borrowing costs, and bankers could even keep their bonuses. But more likely, some combination of the three will happen: lower return on equity, lower bonuses, and slightly higher borrowing costs, to the tune of maybe a couple of tenths of a percentage point.
This is all good. Bankers’ bonuses should be lower. And borrowing from a big bank should cost more: it helps to incentivize borrowers to move their business to smaller, less systemically-dangerous institutions.
Besides, the problem right now isn’t that banks are lending at exorbitant rates: it’s that banks aren’t lending at all. I think many small businesses, especially, would be perfectly happy to pay an extra 0.6% if that meant they could get a loan rather than not get a loan.
And it’s undoubtedly true that the more capital banks hold, the less of a risk they pose to the financial system as a whole.
Right now, there are two huge risks which could result in trillion-dollar writedowns at the world’s too-big-to-fail banks. The first is real estate: prices are still falling in the US and around the world, and at some point mortgages can and should have their principal written down. And the second, of course, is developed-world sovereigns, especially on the European periphery. If they default, then there will be a lot of writing down to go around.
Higher capital levels can’t protect us fully against either of those risks, let alone both of them. But they would help. And if banks build up their capital to a healthy point, then maybe we’ll be able to orchestrate a market-friendly set of global writedowns which doesn’t bring the entire financial system to its knees.
Maybe that’s what the big banks really fear, here: that if they’re asked to build up their capital, that only means they’re going to be asked to write down that capital later. I can see why they wouldn’t be happy about doing such a thing. But for the other 99%, the idea frankly looks rather attractive.