Why Raising Bank Capital Requirements Will Help the Economy

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Outgoing Bank of England Governor Mervyn King once said that he wanted central banks to be boring, because boring was best. Then the crash intervened and finance became so front-page that "Basel III" is something that even the layperson understands.

It's expected that risk aversion increases after a recession, and one of the first pieces of regulation that emerged after the crash – in an industry now being assailed by regulators from all around – was the requirement to increase levels of bank capital. A bank's equity base – its assets minus liabilities – is what it has to protect it from bankruptcy if its assets start defaulting, so naturally Regulation 101 suggests that the more capital a bank has, the safer it will be in the event of economic downturn. So everyone should see the sense of it, yes?

Not so. The chart shows global bank capital levels since the 19^th century, and we see clearly that capital levels have been headed downward for ever and a day. Only the 2008 crash reversed this trend.

Bankers themselves have been shouting loudly from the rooftops that raising capital levels, something that the Basel III regulations require, will reduce what they have available to lend into the economy, and will also increase their cost of funding, which will be passed onto customers.

Both are spurious and fallacious arguments. It is important not to confuse leverage and return on equity (read:profit) considerations with the absolute capital base of a bank. A bank can lend out as much as it raises in deposits, and theoretically this amount is unconnected with what capital it holds. (In the bull market many badly-managed banks lent out even more than they raised in deposits, making up the shortfall with interbank borrowing).

The idea that raising capital requirements means a bank will have to "set aside" more capital rather than lend it is a nonsense. A bank's capital base shouldn't be invested in risk-bearing assets to start with, anyway. What bankers refer to when they say this is that their leverage ratio will have to come down, which means a lower level of relative lending to their capital base. But the absolute level of loans need not be affected.

What about the cost of funds? Bank equity is the most expensive part of its liability structure, yes, but a higher equity base will lower leverage and make the bank a safer and more attractive option for shareholders and creditors. The cost of its debt – and thereby its weighted-average cost of funds – would then decrease as its credit rating improved, so in fact the bank, plus customers, will benefit in fairly short order.

A safer banking system arising out of higher capital levels means more confidence in the sector, lower funding costs and more loan origination as banks raise more deposits. It's the best thing for an economy. Let's knock these objections on the head and move full speed towards reversing the long-term trend illustrated in our chart.

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Professor Moorad Choudhry is at the Department of Mathematical Sciences, Brunel University and author of The Principles of Banking (John Wiley & Sons 2012).