Following this year’s stress tests, most of the major bank holding companies (BHCs) did quite well by the Fed’s standards. The common equity capital ratio increased from 5.3% following the first stress test of 2009 to 12.3% in 2017, representing an increase of $400 billion over this period.
This might sound like good news (it certainly isn’t bad news), but major BHCs financing their investments with only 12.3% equity should be a cause for alarm.
This makes the recent comments of Eric Rosengren, president of the Federal Reserve Bank of Boston, so refreshing.
“He [Rosengren] said the Fed should start requiring banks to increase their levels of loss-absorbing capital, using a rule known as the countercyclical capital buffer. Raising the requirement, currently set at zero, would force banks to boost their capacity to absorb losses during good times, so they are less likely to pull back from lending when a recession begins.”
Anyone willing to come out against the conventional wisdom that the financial system needs to be as heavily leveraged as it is should be taken seriously. “Science,” Max Planck wrote, “advances one funeral at a time.”
Planck, a physicist, was describing how an intellectual “old guard” cements their ideas through their reputation, and how the only way to dethrone older ways of thinking was for their exponents to die.
Institutional bias exists everywhere, but in financial regulation there’s more than an intellectual old guard keeping us from seriously considering fresh ideas to make our financial system safer. Anat Admati explains this phenomenon in her paper “It Takes a Village to Maintain a Dangerous Financial System.”
“The victims are dispersed and are either unaware of the endangerment, misled into believing that the risk is unavoidable or that reducing it would entail significant cost, or they are powerless to bring about meaningful change. Most of those who collectively control the system benefit from its fragility or choose to avoid challenging the system, effectively becoming enablers.”
Admati goes into more detail about how the “village” maintains the financial system, but the short explanation is a combination of nefarious (through misinformation) and well-meaning (through ignorance) methods that prevent those who question the need for excessive leverage from gaining serious traction in macroprudential policy making.
There are, of course, exceptions. Much ink has been spilled on the effects of both higher capital requirements and government bailouts (both implicit and explicit) on our financial system. But the industry’s fierce resistance makes progress a tall order.