Alan Greenspan In Favor of Higher Capital Requirements

Alan Greenspan In Favor of Higher Capital Requirements

History has not been kind to former Federal Reserve Board Chairman Alan Greenspan (1987-2006). Nicknamed “the maestro,” his policy of loosening monetary policy during stock market downturns, called “the Greenspan Put,” is now criticized for increasing moral hazard in the financial system. He also took a great deal of flak in the immediate aftermath of the financial crisis, with detractors accusing him of having too much faith in an unregulated market, based on his history as a devotee of ultra-free-market thinking.

Much like the old joke about how if one hears the Pope doubting the existence of God something interesting is going on, Greenspan’s endorsement of an important (and market-friendly) financial regulation should attract significant attention.

In The Wall Street Journal, Greenspan and his new book’s co-author, Adrian Woolridge of The Economist, make the case for higher capital requirements as a solution to our still unstable financial system:

A better approach [to the “monstrously complicated” Dodd-Frank Act] would have been to focus on the amount of capital that banks are required to hold in order to operate. In the run-up to the crisis, banks on average kept about 8 to 10% of their assets as equity capital. If regulators had forced them to keep 25%, or better still 30%, it would have radically reduced the probability of contagious defaults—the root of all financial crises. Today, despite Dodd Frank, they’ve only increased it to a little over 11%.

Such a move would greatly increase overall confidence in the financial system. It would allow lawmakers and regulators to repeal the bank-related provisions in the Dodd-Frank leviathan with a clear conscience because any bank losses would be absorbed by shareholders rather than by taxpayers.

This is a great example of a solution to the problem of misregulation that runs rampant in our financial sector. The post-crisis reforms, despite producing a great deal of hooting and hollering (some justified, some not) from critics of greater government intervention, only decreased the risk of a banking crisis requiring bailouts within the next century to just 67% from 84%.

But higher capital requirements, as proposed by the Minneapolis Plan, would reduce that figure to 9 percent in the next 100 years.

In addition to concerns related to the rule of law for why straightforward rules are preferable to a laundry list of command-and-control style regulations to be implemented by bureaucrats with varying degrees of accountability, Greenspan and Woolridge find that the costs of this particular regulation would be far outweighed by the benefits based on the historical record:

The usual objection to increasing capital requirements is that it would suppress banks’ earnings and therefore their ability to lend. But a look at history says otherwise. From 1870 to 2017, with rare exceptions, the net income of commercial banks as a percentage of their equity capital fluctuated within a narrow range of 5% to 10% a year, regardless of the size of their capital buffers. This suggests that a gradual rise in banks’ mandated amount of capital would not damage their rate of return or their ability to lend.

Though Greenspan’s tenure as Fed Chairman included many interventions anathema to those in the free-market circles he ran in, his right wing bona fides make him an important ally to financial regulation reformers looking to sell an alternative to the current financial regulatory regime.

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By |2018-10-16T07:31:16-07:00October 16th, 2018|Blog, Financial Regulation|