Will More Bank Capital Prevent The Next Crisis? Not Really

There is a consensus call for more capital for banks and other financial institutions, but unfortunately, more capital (lower leverage) would not have prevented the financial crisis, nor will it prevent the next crisis.

The President, the bank regulators and just about everyone else who has offered an opinion on the past banking crisis say that a low capital requirement was one of the causes of the crisis. Additionally, they say one of the ways to prevent further crises is to have banks hold a higher level of capital than they did during and prior to the financial crisis of 2008-09. Calling for more capital is another way of saying allowable leverage was too high.

Financial institutions holding too large a percentage of assets in real estate investment related securities, loans and companies, in conjunction with a severe drop in real estate prices, caused the banking crisis. When the value of real estate declined by much more than anticipated by the majority of borrowers, lenders and investors, the financial institutions' over investment in real estate caused firms to suffer huge real estate related (paper and realized) losses. Major financial firms faced increased insolvency, liquidity and collateral risks, which froze the credit markets.

While there is a mathematical amount of capital that is sufficient to allow the banks to write off all their bad and devalued real estate related holdings, nobody is suggesting that banks hold that large of an amount of capital. The extent of the real estate investment along with the extent of the decline in real estate prices caused losses at the major financial firms that far exceed any reasonable amount of held capital.

Regulatory Insolvency Triggering Events

Regulators use capital amounts as triggering events to determine when they should declare an institution insolvent and take it over. From their point of view, it makes sense to have more capital because it decreases the number of likely triggering events. The past, recent crisis would still be a regulatory insolvency triggering event because the losses were so great that many institutions even with higher capital amounts would still be found insolvent. Additionally, increased capital requirements lower the leverage ratio of firms, and therefore likely the total dollar amount of real estate investments held, but increased capital does not prevent an over concentration in real estate related investments and loans. Severe losses in these investments and loans would still make the banks insolvent, even with higher capital.

Furthermore, capital is not the same as money in the bank. It is an arbitrary regulatory accounting concept. It reflects the sum of all past equity and equity-equivalent investments in the banks plus all profits less any dividend payouts, income losses and other capital reducing events.

Capital does not represent the value of the institution, nor the net proceeds from sale of its assets after paying the debt. The capital amount gives no indication about the future business and investment prospects of the financial institution. As I said above, capital is useful for regulators because it allows them clearly and mathematically to define a triggering event for government takeover of the financial firm. It also allows the regulators to show that they have taken action to prevent another crisis, but low capital levels were not the cause and high capital levels will not prevent another crisis.

Part of the past crisis was the over investment in real estate and the significant real estate price declines. Increasing capital ratios at financial institutions does not prevent over concentration in an asset class nor does it prevent major price declines.