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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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About the Author

Stephen G. Cecchetti is Professor of International Economics at the Brandeis International Business School, Research Associate at the NBER, and Research Fellow at the CEPR, former Chief Economist at the Bank for International Settlements, and former Director of Research at the Federal Reserve Bank of New York.

Kermit L. Schoenholtz is Professor of Management Practice in the Department of Economics of New York University’s Leonard N. Stern School of Business, Director of NYU Stern’s Center for Global Economy and Business, a member of the Financial Research Advisory Committee of the U.S. Treasury’s Office of Financial Research, and former Global Chief Economist at Citigroup.

References
1. Schlesinger, Jacob M., “Trump Treasury Choice Steven Mnuchin Vows to ‘Strip Back’ Dodd-Frank,” Wall Street Journal, 30 November 2016.
2. See http://financialservices.house.gov/choice/
3. See Schularick, Moritz and Alan M. Taylor, “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870-2008” American Economic Review, Vol. 102, No. 2, April 2012, pp. 1029-61.
4. See Cecchetti, Stephen G. and Kermit L. Schoenholtz, “Ending Too Big to Fail,” www.moneyandbanking.com, 28 November 2016 and The Minneapolis Plan to End Too Big to Fail, Federal Reserve Bank of Minneapolis, 16 November 2016.
5. See Cecchetti, Stephen G. and Kermit L. Schoenholtz, “Higher capital requirements didn’t slow the economy,” www.moneyandbanking.com, 15 December 2014.
6. Cecchetti, Stephen G. and Kermit L. Schoenholtz, “Bank Capital and Monetary Policy,” www.moneyandbanking.com, 20 June 2016; and Gambacorta, Leonardo and Hyun Song Shin, “Why Bank Capital Matters for Monetary Policy,” BIS Working Paper No. 558, April 2016.
7. See Caballero, Ricardo J., Takeo Hoshi and Anil K Kashyap, “Zombie Lending and Depressed Restructuring in Japan,” American Economic Review, Vol. 98, No. 5, December 2008, pp. 1943-77.
8. See Acharya, Viral A., Tim Eisert, Christian Eufinger, and Christian W. Hirsch, “Whatever It Takes: The Real Effects of Unconventional Monetary Policy,” unpublished manuscript, October 2016.
9. See Cecchetti, Stephen G. and Kermit L. Schoenholtz, “Rolling the dice, again,” www.moneyandbanking.com, 21 October 2014.
10. For a broader list and discussion of Dodd Frank’s accomplishments and failings see Cecchetti, Stephen G. and Kermit L. Schoenholtz, “Dodd-Frank: Five Years After,” www.moneyandbanking.com, 15 June 2015.

 

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