How much capital does a bank need?
That’s the two trillion dollar question. Two trillion, by the way, is the approximate total loss that the global banking system had to absorb from mid-’08 to mid-2010. Capital is the amount of equity that a bank’s shareholders have at risk in their institution. The lower the capital requirement, the higher the potential return—but also the greater the risk that the bank could be wiped out. If the banks all get wiped out at the same time, a credit-induced depression is possible. That’s what happened in the ‘30s, and that’s what almost happened in ’08. That’s why every modern society has a stake in its banking system.
This summer global regulators will decide how much capital to require. The rumor is, they’ll be arguing for a 10 percent downpayment, as opposed to the current 8% requirement. The BIS, a global central bank, recently pegged the ideal level at 13%. Europe currently only requires 4%, based on increased mark-to-market disclosure.
The challenge is this: regulators have been pounding on banks since 2008 to upgrade their loan portfolios and reduce their exposure to rising interest rates. At the same time, they want the banks to raise more capital. But if the risk is all taken out of banking, what can they earn? And then who’s going to invest in the banks? You can’t raise investment capital by promising no returns.
So if the banks can’t raise capital but have higher capital requirements, what can they do? They can shrink. That may sound fine to academics and activists, but in the real world shrinking balance sheets exact real costs: loans not made, businesses not started, homes not built. With unemployment at 9%, that’s not what we need right now.
More equity in the banks is a good idea. But getting there is more than half the challenge.
Douglas R. Tengdin, CFA
Chief Investment Officer
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