The Political Case for Above-Optimal Capital Requirements

The Political Case for Above-Optimal Capital Requirements

Banks across the US are currently just shy of 11.5% financed by equity . As part of a general upward trend, this is undoubtedly a positive development, though most experts believe that capital requirements should be significantly higher, closer to about 20%. The Minneapolis Plan to end Too Big to Fail would impose a 23.5% requirement (for the safest financial institutions), and even Alan Greenspan opined favorably on a counterfactual in which regulators had forced banks to be financed by “25%, or better still 30%” in equity in the run-up to the financial crisis.

Most of these models are based on complicated economic modeling, balancing the costs of reduced lending and those of bank failure, but one thing that is difficult to build into these models is the cost of the subsequent polarization and general political dysfunction caused by a financial crisis.

And those designing macroprudential policy would be foolish to ignore the costs of polarization as a product of failure in the financial system. As Amir Sufi writes in Chicago Booth Review:

Research I’ve conducted with Atif Mian of Princeton University and Francesco Trebbi of the University of British Columbia suggests a reason politics has come to this: an increase in polarization after banking and financial crises is common and predictable.

What makes a financial crisis energizing to the populist right is that the demand for assistance to both creditors (banks) and debtors (homeowners) generates outrage for those generally opposed to government intervention in the market:

And so the Tea Party was born out of anger that debtors would get special breaks at a time when creditors already had gotten plenty. The Tea Party movement got even stronger during the battle over the Patient Protection and Affordable Care Act (better known as Obamacare) in 2009 and 2010, and its central issue became rapid expansion of government debt, but its initial impulse was to unite against any breaks for debtors in the wreckage of the financial crisis. [Emphasis added]

Sufi and her colleagues find a similar outrage on the left, except the opposition is directed to creditors:

Just weeks [after fiscal brinkmanship cost the U.S. its AAA credit rating], demonstrators occupied a park in lower Manhattan, protesting income inequality, foreclosures, Wall Street corruption, and the power of money in politics. With their soon-to-be-famous slogan “We are the 99 percent,” the Occupy Wall Street movement spread quickly across the country.

Though the Occupy movement probably had less direct political impact than the Tea Party did, the two movements uncannily illustrate the debtor-creditor split after financial crises, with the Tea Party siding against debtors and the Occupy movement with them.

In addition to Sufi’s piece, we have other evidence that the financial crisis contributed to, if it did not directly cause, our current populist age. Take this quotation from Tim Alberta’s recent book American Carnage:

[T]he entire episode [of TARP] was scarring for millions of Americans who became convinced that Washington and Wall Street were playing by a different set of rules; that the economy was rigged against them; that professional politicians had sold them out.

“McCain came back to bail out the banks. He had a chance. I was hoping he wouldn’t vote for it,” says [Congressman Jim] Jordan. “That was when the populist sentiment started to take root in the country. I think that was probably laying the groundwork for what happened in 2016.”

Why does this matter for macroprudential policy? For the sake of argument, let’s assume that in a purely technocratic and apolitical world the optimal capital requirement is 20%. This model would certainly try to minimize the risk of a financial crisis, but it would be unreasonable to bring it down to zero. For the same reason I get a flu shot but don’t wear a hazmat suit, there is an acceptable level of risk of catastrophic failure in all policy domains, financial regulation included.

But the above example doesn’t factor in the risks associated with the subsequent political dysfunction caused by financial crises. The decision of which institution to bail out, if any, is a difficult one, and this purely technocratic decision can become muddled by (justified) outrage from both the left and the right over such a dramatic form of government intervention. To factor in these costs would require a “political buffer” be added onto the “technocratic” capital requirement.

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By |2019-10-29T10:19:32-07:00October 29th, 2019|Blog, Financial Regulation|