The debate around the value of having higher capital requirements requires that we understand exactly what the extra capital does and how it reduces the impact of financial crises. Anyone interested in this topic will I think find this post on the Croaking Cassandra blog worth reading. The author is commenting specifically on the recent policy decision by the RBNZ to increase capital requirements but his post can be read as a more general exploration of some of the reasons why a banking system can experience substantial losses and in particular the impact of poor lending practices.
Having established this point , the author then makes the obvious (to me at least) point that capital can help protect bank creditors and ensure that banks can absorb losses and continue to operate but the capital itself cannot do anything to eliminate the costs to the economy of the poor lending itself that created the losses. The capital will help ensure that the impact of the initial losses is not compounded by a freezing up of bank lending but it will not eliminate the adverse GDP impacts of the poor lending that had to be written down or off. That I believe is an important distinction that is often ignored in the bank capital debate.
“Higher bank capital might stop the eventual realisation of the losses falling directly on bank creditors and depositors (that redistributive effect, see above) but it won’t stop the losses themselves (on the bad projects that were funded), it won’t stop those particular markets seizing up and demand no longer being there (no one much wanted to build any more new offices in late 1980s Wellington after the scale of the incipient glut became apparent), it won’t stop people across the economy (lenders, borrowers etc) having to stop and reassess how they think the economy works, their view on what might really be viable projects and so. And they won’t stop the realisation of wealth losses – the wealth that was thought to be there has gone, the only question is who now actually bears the losses.”
The post concludes with a consideration of what the best response should be.
If it really is sustained periods of greatly diminished lending standards that lead to most of the eventual costs the Bank is worrying about, it might be better for the Bank to be focusing more of its energy on understanding bank lending standards and how they are changing, and on understanding and drawing attention to important distortions in the policy or regulatory system that may be misleading borrowers and lenders alike, and so on. I’m not that optimistic that bank regulators can really make that much difference – for various reasons (including their own personal incentives) it is hard to imagine even the best central banks being that influential with governments, or being paid much heed by banks (let alone borrowers and investors not reliant on local credit). But really high capital ratios have a substantial cost to the economy and it just obvious that they are particularly potent as an instrument to limit the sorts of (overstated) costs the Bank worries about. Other big policy distortions, messing up incentives, making it harder to lend or borrow well, might just be one of the messy facts of life. High capital ratios will always appeal to central bankers – when your only tool is a hammer, all problems tend to be interpreted as nails – but they are costly for the economy and whatever gains (beyond the merely redistributive) they offer seem, from experience, likely to be slight.
And what we do need when things go badly wrong, and a whole of reassessment is taking place, is a robustly counter-cyclical monetary policy. The worst costs of serious economic shocks and misperceptions crystallised are around sustained unemployment for the individuals affected. Neither monetary or bank regulatory policy can do much about potential GDP growth or productivity, and they can’t prevent real wealth losses when bad choices have been made in the past, but they can do a great deal to alleviate the adverse cyclical consequences, to keep unemployment as low as possible, consistent with price stability, and deviations from that (unobservable point) as short as possible.
You may not agree with his analysis but the post is worth reading