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How to Think About Mega-Bank Capital Requirements

The agreement reached in Basel this weekend seems far better than I would have expected.

The world’s largest banks—officially called Sifis, or Systematically Important Financial Institutions—will be required to hold additional capital buffers comprised entirely of common stock.

The buffers will work on a sliding scale from 1 percent to 2.5 percent depending on the size of the bank, which is entirely sensible.

Regulators appear to have rejected batty ideas like using convertible debt instruments instead of common equity.

Unfortunately, the fight is not quite over. Banks will still push hard to get capital requirement regulations watered down. They appear to have France, Germany, and Canada, as well their favorite captured U.S. regulatory agency, the Office of the Comptroller of the Currency, on their side.

Even before the rules are formally presented for comment at the end of July, the Sifi Sarumans will be sending forth their little Wormtongues to whisper into the ears of the heads of state.

Republican lawmakers in America seem to be predisposed to side with the Sifis when it comes to capital requirements. Apparently, the capital rules rub their anti-regulatory organs the wrong way.

Hopefully, some of them will quickly realize that this is one of the few times their libertarian instincts are misfiring.

Bank capital requirements are not an instance of the government interfering with the operation of the free market. The market in bank capital is already not free because of various explicit and implicit government guarantees of bank liabilities.

At the very basic level, there is deposit insurance. This provides security to bank customers, rendering them largely passive counterparties to banks. This allows banks to put deposit bases at risk at levels that would otherwise trigger a run on the bank. Bank capital requirements at insured institutions are an attempt to rebalance the distortion caused by the original intervention of deposit insurance.

When it comes to Sifis there is another problem: Their bonds are considered to be safer than those of smaller institutions because investors do not believe they would be allowed to fail. In other words, Sifis are too big to fail.

The implicit guarantee lowers the cost of funding for the Sifis, giving them an advantage over smaller competitors—the same way Fannie Mae’s implicit backing allowed it to dominate the housing market. As a result, the Sifis grow bigger, and gobble up smaller banks with higher funding costs. They take outsized risks because the market doesn’t monitor their risk as closely as it should.

Higher capital requirements for the Sifis restore a bit of balance to the market, taxing the funding subsidy and balancing out the perverse incentives created by the implicit guarantee.

In short, Sifi capital surcharges should not be viewed as the government intervening in the market. Instead, they are the governments of the world attempting to undo some of the damage they’ve already done.

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