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The Truth About Bank Capital

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Joe Nocera in the New York Times has decided he's in favor of more bank capital. In his column, he makes this seem like his personal endorsement is necessary to push across the line what he calls "the most important reform moment since the financial crisis broke out three years ago. More important even than the wrangling over Dodd-Frank." Well, this falls within the pundit's right to hyperbole, as the headline on the column, "Banking's Moment of Truth," falls within the bounds of the headline writer's exaggeration exemption -- though the more I look at it, the more that "truth" bothers me. Personally, turning to the most important person in the world -- moi -- I would, if forced to take a stand, vote for higher capital standards for the big banks, though the question is not nearly as clear and straightforward as Nocera makes out. There's not a lot of "truth," or a lot of empirical economic evidence arrayed against any of this. There's intuition, gut feel, a sense that something must be done and lots of credentialed and noncredentialed opinions. Both Dodd-Frank and the bank capital standards are classic economically driven arguments that will be judged by future performance and consequences that, unfortunately, we have no way to predict. It's like voting for a president.

Nocera gets the basic argument essentially right. Generally, the more equity you amass, the less debt you can take on. That will tend to dampen leverage and, as we know, leverage was one of those evils at the center of the crisis. Nocera's blithe confidence that if Merrill Lynch & Co. and AIG had had "adequate capital requirements" those two firms would not have been bailed out is a stretch, given the shadow banking system that grew up and the obvious failures of oversight. How does he explain Bear Stearns Cos. and Lehman Brothers? How do you factor in the degree of sheer panic as opposed to inadequate capital that threatened all firms? Nocera is correct that a larger equity capital cushion does provide a way for banks, rather than taxpayers, to absorb more losses. But there are no guarantees. Banks have been collapsing for centuries. Even the Swiss, which have already mandated capital of 19% (both in equity and so-called contingent convertible bonds), well above anything Basel III envisions, know that banks stuffed with capital can collapse. Indeed, the most obvious sign of trouble is the belief that your capital is adequate to withstand stupidity and disaster. Historically, there seems to be a positive relation between stupidity and excess capital (although, to be fair, thin capital may be evidence of recklessness as well).

Nocera stacks the deck a bit. He wheels out "bank expert" and one of DealBook's house pundits, Simon Johnson, with Stanford's Anat Admati, both of whom he insists have "demolished" the arguments "put forth by the big banks and their Congressional spokesmen against higher capital requirements." Indeed, Johnson, who has actively promoted Admati as the voice of wisdom on this subject for months, does offer up a clear outline of the position for higher capital requirements on his blog, The Baseline Scenario. But as with nearly everything Johnson touches, the nuances drain away and everything goes to black and white. Besides, turning back the arguments of lobbyists and politicians on a subject as arcane as this is sort of like debating particle physics with a Hollywood star on Bill Maher.

What are the reservations here? They begin with the question lobbed at Ben Bernanke by J.P. Morgan Chase & Co.'s Jamie Dimon on what economists know of the relation of bank capital to jobs. Bernanke admitted that not much is known; in other words we're guessing. Johnson argues that the job issue is a false one with capital -- that lending is not related to the amount of equity you're required to pile up. That's right, technically. But we also know that higher levels of equity will tend to depress returns on equity over time, all things being equal. Lower ROEs might well be something to applaud; one of the better arguments for how we got into this mess was that both managers and shareholders of the big banks began to feel that a 15% ROE was a reasonable, if ambitious-bordering-on-reckless, benchmark to aim for. Shareholders came to expect that -- or at least an effort to reach it -- and rising executive pay hung on the share prices that resulted. The big banks were thus pitted against public investment banks and every other company in the market, probably to their detriment and ours. An unhealthy race to the bottom began.

More equity would make those targets infinitely more difficult to hit. Banks would look a lot stodgier. Again, this might be just what the doctor ordered, but it's not hard to see the unintended consequences. Bank executives would search for businesses that could get more horsepower, and that inevitably means taking on more risk, thus making more demands on regulation, which will inevitably fail at some point, the likelihood rising with time and success.

And what about those jobs? Perhaps lending would not be affected by the increase in equity capital. But what, these days, do we define as lending? Do we mean credit cards, mortgages, corporate loans, securitizations, structured finance? Do we mean big loans to strategic M&A deals, private equity buyouts or prime brokerage? How far into the middle market will this lending extend? The unfortunate reality is that we've evolved an economy that feeds off a finance sector, including the big banks, that is, highly liquid, highly differentiated (by product) and highly speculative. It's easy to say from MIT, as Johnson does regularly, that we need to immediately shatter this "addictive" finance-heavy system (he was a major proponent of breaking up the banks); that's Bill Maher talk. And it's easy to say in the long run we'll be better off -- though we have no idea what the long run will hold. But any "reform" we make at the big banks will inevitably have immediate consequences throughout an extremely complex and highly evolved real economy (really a nervous, psychologically sensitive and slightly wacked-out political economy), which already suffers from serious structural woes and lackluster growth. So it's not just the anxiety that fewer loans will be made; it's a sense that for all of our technical expertise, we have no real consensus what the drivers of this economy -- or some "better" and future economy -- really are. We only have economic pundits, from this camp and that, offering views and back-of-the-envelope calculations.

That's why I hesitate, not that I have a vote. All that said, the kind of surcharges and capital increases being discussed for Basel III and attributed in the U.S. to the Federal Reserve's Daniel Tarullo, seem reasonable, even sensible. But these increases -- even at the nosebleed levels of the Swiss -- resemble earthwork levees thrown up in the face of a flood more than hardened bulwarks against bailouts. They are hardly guarantees. And they will spawn consequences we have not anticipated.