JPMorgan CEO Jamie Dimon ripped into Mark Carney this week in a closed door meeting over Carney's support of increasing the regulatory requirements on banks which are perceived to be too big to fail. While Mr. Dimon is probably the most vocal critic, he is certainly not alone. So what is this fight all about?
The business of banking is inherently unstable. Deposits, which can be withdrawn at any moment, are used to fund loans that are both risky and often illiquid. For instance, if during a drought too many farmers became insolvent and default on their loans then depositors are at risk of losing their savings. Once this fear sets in a bank-run can follow, deepening the problem, as the cash in vault gets depleted pretty fast.
Today we minimize the risk bank runs with deposit insurance and a discount window. Deposit insurance means most depositors will not lose their savings, regardless how many bad loans a bank makes. The discount window ensures that a bank can have sufficient cash on hand to meet any spike in withdrawals. All of this comes with a catch, however, in the form of greater oversight.
Ensuring that the owners of the bank have sufficient cash in reserve to absorb loses is one of the most important ways regulators minimize the risk of actually having to deliver on their guarantee to depositors. Thanks to some creative accounting, and being able to convince regulators that risk management techniques were more advanced than they evidently were in practice, the actual size of the buffer was greatly reduced over the decades leading to the great recession.
World regulators, recognizing that the rules had loop holes and shortcomings, have been busy trying to address these concerns (known as Basel III) since the onset of the crisis. Many of the proposals have been uncontroversial, but more recently an idea has been floated to apply additional requirements on banks that are considered systemically important and therefore 'too big to fail'. This has greatly perturbed the likes of Mr. Dimon, who happens to head a bank that would be on that list.
These cash buffers are more commonly referred to as capital requirements and, while higher requirements might reduce the risk of a bailout, holding more capital increases the funding costs of banks. It's probably pretty clear why some top bankers don't like them, but a good argument can be made that increasing these requirements beyond a certain point is not optimal for the broader economy either.
A worry is that the higher costs will just be passed on to the public. A 2011 working paper by the OECD on the Macroeconomic Impact of Basel III estimated that for a 1 per cent increase in capital requirements borrowing costs might increase by 20.5 basis points in the United States and up to 14.3 basis points in Europe. As a result, the authors estimate GDP growth in the OECD could be slowed by between .05 and .15 percentage points per year when fully implemented. And these estimates were done before the proposed additional capital requirements now being discussed.
What many critics of more strenuous capital requirements are now advocating is that additional capital charges are not the most efficient way of reducing risks to the financial system and that other methods should be looked at that might have less of a trade off (i.e. through better transparency and risk management oversight). They might have a point, but given past shenanigans their concerns might be falling on less than sympathetic ears.
Most of the new capital regulations are expected to be phased in over a long time horizon, so as to lower any potentially negative impact, but we should expect the rhetoric to increase as policy makers finalize the new rules over the coming months.
Will Van't Veld, economist, ATB Financial.
