Georgios Kefalas/Keystone, via Associated PressThe Bank for International Settlements’ building in Basel, Switzerland.Was the United States government savvier about its banks than the Europeans?
Banks with inadequate capital are vulnerable to losses on their loans and securities and can become a source of instability for the whole financial system. As a result, regulators around the world have been taking measures to increase the capital loss buffers at their banks.
But in doing so, they face two major challenges.
The first: How do you keep banks from meeting their capital requirements by decreasing their holdings of loans and bonds?
Such asset reductions can damp economic growth. On Monday, the Bank for International Settlements released a report that said shedding assets was likely to have played a “small part” in Europe’s most recent bank recapitalization plan.
The Europeans have also expressed their capital target as a ratio. By the end of June, one crucial measure of capital at Europe’s largest banks needs to be equivalent to 9 percent of risk-weighted assets.
The United States deliberately did things differently. As part of the bank recapitalization plan that went along with the 2009 bank stress tests, American regulators chose not to express its target as a ratio, since it can crimp lending.
Capital ratios divide a bank’s capital by the amount of its assets, so that $8 billion of capital supporting $100 billion of assets gives a capital ratio of 8 percent. If regulators said the bank had to hit a 10 percent capital ratio, it could simply cut assets to $80 billion rather than increase the dollar amount of capital from $8 billion.
By contrast, American regulators stated in 2009 that banks had to hit a certain dollar amount of capital. As a result, banks could not achieve their capital targets by reducing assets.
“We specified the capital need in terms of dollars rather than in terms of a capital ratio,” William C. Dudley, president of the Federal Reserve Bank of New York said in 2011. “In other words, we did not allow banks the option of shrinking their risk-weighted assets in order to push up their capital ratios. We didn’t want banks to shrink to minimize the amount of capital needed because such behavior might have damaged the macroeconomy.”
Franca Rosa Congiu, a spokeswoman for the European Banking Authority, said the regulator took steps to avoid asset reductions that would hurt the wider economy. Its capital plan stated that any asset reductions that had “a direct impact on lending to the real economy would not be considered for achieving the 9 percent target.”
The second challenge with capital plans involves banks’ stock prices.
A typical way to increase capital is to issue new shares. But if investors believe a bank is going undertake a big capital raise, the bank’s share price is likely to decline in advance of the share sale, forcing the bank to issue an increasing number of shares to fill the capital gap. If that process feeds on itself, a bank’s stock price can go into a tailspin, which can lessen the general appetite for bank shares and damage the wider capital plan. UniCredit’s share issue earlier this year behaved a lot like this.
But the Americans’ 2009 bank capital plan had a little-noticed feature that potentially removed this threat. The United States government said, if necessary, it could make capital available out of its bailout fund to banks based on a preset share price that in most cases would not have been punitive.
Banks rarely took this option, because they didn’t want the stigma that comes with having a government stake, and because private investors were willing to provide the capital. But its existence may have played a crucial role in protecting banks from speculative attacks aimed at creating death spirals in their stocks.
Granted, the latest European bank capital plan recommends that “government backstops should be made available” to make up any capital shortfalls. And European banks may not have wanted to tap such backstops, because, like their American counterparts, they don’t want their government as stakeholders.
Even so, the Americans appeared to better understand the dynamics surrounding the 2009 bank capital raises. That may have helped bolster confidence at a time when, as with Europe today, a large degree of nervousness was swirling around the big banks.