A Capital Idea Gone Bad?
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When you are sick and the doctor gives you medicine, you have to take it in the dosage prescribed or else you may have more trouble. Too little medicine may make you sicker, too much medicine and you may die as a result.
Capital requirements for financial institutions are no different.
Capital requirements are prescribed by regulators to ensure that a certain amount of liquidity is on hand to allow a financial institution to meet its obligations. Too little capital on hand and the financial institution won’t survive in the short-term, too much capital on hand and the financial institution will have less to lend, be less profitable and underperform. Not a recipe for long-term success.
One of the lessons of the financial crisis was that the capital standards set by regulators may have been inadequate to manage the risk profiles of firms. Bear-Stearns was well capitalized, according to the existing rules, on the day it went under. As a result, regulators – domestically and internationally – have been toughening capital standards and the Dodd-Frank Act gives regulators the authority to boost capital held by financial firms if it is determined that they engage in risky behavior.
The Chamber has been supportive of these efforts. Adequate capital standards are important to provide stability within the financial system, forming a foundation of certainty that will allow the economy to grow and move forward in creating jobs. In fact, last year during the Dodd-Frank debates, the Chamber suggested higher capital standards in opposing the Volcker Rule – which prohibits banks from engaging in certain kinds of business activities. Heightened capital requirements would allow firms to be market makers and provide clients with positions while mitigating excessive risk.
But like all things, too much of a good thing can quickly turn bad.
Bank regulators from around the world are negotiating a new agreement to set global international capital standards. This round of negotiations is known as Basel III. The United States is a party to the negotiations, but it should be noted that the previous agreement, Basel II, was not implemented in the United States because the rules were not deemed tough enough.
As part of the Basel III negotiations, a proposal is being considered to assess a capital surcharge of 3% upon Globally Systemically Important Financial Institutions (GSIFI’s for your Dodd-Frank/financial crisis glossary). Essentially, Basel III will toughen capital standards for all and then add another 3% of capital to be held by the largest financial institutions.
How is that too much of a good thing?
All of the other major economies have rejected any imposition of the Volcker Rule and the Dodd-Frank Act will allow financial regulators to make the capital standards tougher than anywhere else around the world.
In effect, we have created a system where our largest financial institutions, domestically, will not resemble what a full service financial firm will look like in other parts of the world. This is not a matter of a race for the bottom, but rather that domestic customers may not have the same access to forms of capital that other global actors may.
So in short, the Volcker Rule does not allow firms to provide a full array of access to the markets that our competitors do, while the larger firms will also have to hold more capital despite these restrictions. By holding more capital than would otherwise be required, these firms would have less available to lend to businesses.
The GIFI’s surcharge could cause a credit squeeze here in the United States that will ultimately make it harder for main street businesses to get a loan to expand and create jobs.
The Chamber sent a letter to the Federal Reserve expressing these concerns and asking for a study to determine the impacts of a GIFI’s surcharge before coming to an agreement.
Too much medicine may not be a good thing. Let’s figure out the dosage so we don’t kill the patient.