Better Capitalised Banks Lend More and Lend Better

February 14, 2017 • FINANCE & BANKING, Governance & Regulation

By Stephen G. Cecchetti & Kermit L. Schoenholtz

Are higher capital requirements really a drag on economic growth? Many people seem to think so. We disagree. In this essay, we describe how better capitalised banks experience lower funding costs, and how undercapitalised banks have an incentive to “evergreen” loans to low-quality firms. Our conclusion is that higher capital requirements are good for economic growth, resulting in both more lending and better lending.

Many people seem to think that when capital requirements increase, banks lend less. Adherents of this view go on to argue that, since credit is essential for economic growth, we should not impose overly tough constraints on banks. This is the basis for the conclusion that we have gone too far in making the financial system safe and the cost is lower growth and employment.

US Treasury Secretary-designate Steven Mnuchin appears to share the view that financial regulation has restrained the supply of credit: in a recent interview, he is quoted as saying “The number one problem with Dodd-Frank is that it’s way too complicated and cuts back lending.”1 One interpretation of this is that Secretary-designate Mnuchin will support proposals like House Financial Services Chair Jeb Hensarling’s Financial CHOICE Act to allow banks to opt for a simple capital standard as an alternative to strict regulatory scrutiny.2

Our reaction to this is three-fold. First, for most US banks, which are very small and pose little threat to the financial system, a shift toward simpler capital requirements – so long as they are high enough – may be both effective and efficient; for the largest, most systemic intermediaries, higher capital requirements should still be accompanied by strict oversight. Second, we see no evidence that higher bank capital is associated with lower lending. In fact, quite the opposite. Third, given that the 2007-09 financial crisis was the result of too much borrowing, not all reductions in lending are bad. We take each of these points in turn.3

Recently, we wrote about the Minneapolis Plan to End Too Big to Fail and its proposal to sharply increase required equity in the 13 largest US banks.4 Specifically, the Minneapolis Plan calls for a pure leverage ratio – the ratio of common equity to total assets – of at least 15% and possibly as high as 24%. The current requirement is 6%, and the CHOICE Act would require only 10%. Unlike the CHOICE Act, the Minneapolis Plan also embraces important aspects of current regulation (including stress tests and living wills) to contain the systemic risks of the largest, most complex, and most interconnected banks, while simplifying regulatory compliance for small banks that do not pose a threat to the financial system. We believe that the Minneapolis Plan provides a solid basis for legislation that would advance the public goal of making the financial system safe in a cost-effective way.

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