Are the big banks finally safe?
Picture: New York Fed
The Financial Crisis put bank safety and soundness fully in view. The serial bailouts or failures of Bear Stearns, AIG (NYSE:AIG), Fannie (OTCQB:FNMA) and Freddie (OTCQB:FMCC), Lehman, Merrill, and Washington Mutual put the global economy at risk. The problem was systemic: all the big banks were affected, because investors weren't certain where their money would be safe. Bank stocks fell about 70%, and yields on their bonds rose about 4%.
When this happens, banks cut back on their lending, which slows the economy because businesses can't borrow the money they need to grow. What the banking system should do at this point is raise more capital so they can keep lending. But there's little incentive for any company to do this: the economy is weak, levered institutions are more risky, and stock prices are low. Why sell more stock when the price is low? That's a good way to get your owners angry.
According to Fed data, the banking system is better capitalized than it has been in years. Of course, the data showed that just prior to the financial crisis as well.
Source: St. Louis Fed
If individual banks chose to keep their equity levels high all the time, that would prevent us from having a banking crisis, but there is little incentive to do this. A higher equity level means a lower return on equity, and lower returns for shareholders.
Because of this, Fed officials have considered whether subsidizing equity issuance could help. That is, for every dollar in capital the banks raise, the government would kick in 50 cents of its own money - into bank capital. Such an approach would reduce the chances of another financial crisis and improve future economic growth by as much as 1% per year. That's a lot of growth: imagine how much better the world would be if we never went through the Great Recession.
But subsidizing bank capital is a non-starter, politically. Bankers aren't very sympathetic characters. If you cruise the comments section of any prominent newspaper, people still wonder why the executives in charge of the big banks during the Financial Crisis were never put behind bars. The last time a banker was portrayed positively in the movies was George Bailey in "It's a Wonderful Life" (1946), and he was considering suicide when his capital fell short.
Banks are essential - they provide the capital that the modern world needs to grow. But they are subject to booms, busts, and periodic panics. The only way to have a risk-free banking system would be to regulate their returns. And then you wouldn't have enough banks - or enough capital to grow.