The Dangerous Pointlessness of Bank Capital Requirements

It cannot be stressed enough that businesses never run out of money. Instead, they run out of investor trust. A corollary is that capital markets are always open for well-run businesses.

It’s something that rates substantial attention right now as Federal Reserve officials bruit the mindless possibility of increasing capital requirements for banks. There’s no good purpose served here.

The simple, obvious truth is that banks pay a rate of interest in order to “rent” savings from depositors. They profit from the careful lending of savings entrusted to them, and their profits come in the spread between rate of interest paid for deposits and rate of interest at which the deposits are loaned.

Bank capital requirements lay a wet blanket on profit making. Call them an obnoxious tax. Banks rent savings, only to be limited in their ability to put those savings to work. At present, the Fed wants to sideline even more of the capital rented by banks. There’s an obvious cost here. The interest they can earn on their sidelined capital isn’t as much as what they could earn if regulators weren’t aggressively trying to limit the raison d’etre of banks.

It’s just a reminder that the only proper capital requirement for banks is no capital requirement. Let them do what they exist to do. Reader heads are surely exploding at this point.

Don’t you know, the capital requirements are just a way for banks to have funds in reserve should economic or bank-specific problems rear their ugly head. Bank capital requirements are just a healthy way of positioning them for the unexpected. It all sounds so innocuous and reasonable, except that it’s not.

For one, if capital requirements are as sensible as Fed officials say, then regulations to enforce what’s said to be sensible are plainly superfluous. Really, who needs to be forced to do that which is said to cushion banks in times of trouble?

Second, there’s still the problem of paying for savings that can’t subsequently be deployed. If banks operated under 100% capital requirements, or close to it, they would quickly be insolvent; the latter raising a question of why even a little of what’s so crippling for a bank is a good thing. Banks take in deposits (liabilities) so that they can lend them out (assets), so let them do just that. As for them carefully lending the money out, that goes without saying. Since banks profit from interest spreads as opposed to owning the full loan made, they have every incentive to put the savings entrusted to them prudently.

All of which brings us to the biggest problem with capital requirements: they sap bank profitability without providing any realistic cushion in times of trouble. See this write-up’s introduction to understand why: banks, like any other business, never run out of money as much as investors run out of trust in them.

Assuming a bank hits serious trouble, the capital cushion foisted on them by regulators will in no way protect them. Which should be a statement of the obvious. That’s because the very notion of a capital requirement implies having funds in reserve when capital markets are “closed” in the figurative sense, and nosebleed expensive in a literal sense. Put another way, if the economy sinks, if bad loans sink a bank, or both, the capital cushion will quickly be rendered too small, and by extension, meaningless.

Which means bank capital requirements are simply dangerous. They sap profitable activity in the near-term, all the while serving no safety purpose in the long term. Let’s not expand what’s never made sense.