James R. Barth
Senior Fellow
Banking and Capital Markets and China and Europe and Financial Innovations and Global Economy and Public Policy and Real Estate and U.S. Economy
Dr. James R. Barth is the Lowder Eminent Scholar in Finance at Auburn University and a senior fellow at the Milken Institute. His research focuses on financial institutions and capital markets, both domestic and global, with special emphasis on regulatory issues.
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Good and bad news as big banks race to meet more stringent capital requirements
By: James R. Barth
October 24, 2012
The global financial crisis has led bank regulators in countries around the world to rethink capital requirements for banks. Indeed, the 27 members of the Basel Committee on Banking Supervision (BCBS), which facilitates international cooperation on banking supervisory matters, has concluded that too many banks got into serious trouble because they were inadequately capitalized. The BCBS has recommended that higher capital requirements be imposed on banks to ensure they are better able to withstand unexpected losses in the future.

The thinking of the BCBS is expressed in the Basel III capital standards issued in 2010-11. The new capital standards are extra stringent for 29 financial institutions identified as Globally Systemically Important Financial Institutions (G-SIFIs). These are big institutions whose troubles are most likely to spill across national borders. Among the G-SIFIs are eight large U.S. banks: Bank of America, Bank of New York Mellon, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan Stanley, State Street and Wells Fargo.

In order to give the G-SIFIs sufficient time to meet the tougher standards, the standards are phased in over a six-year period beginning on January 1, 2013. So how much progress has each of the eight big banks made before the standards take full effect?

The figure below depicts their progress as of the second quarter of 2012. There are four basic capital ratios that we focus on due to limited data availability. One is the leverage ratio, or the ratio of common equity capital to total assets. The other three are risk-based ratios or ratios of common equity capital to total assets, with adjustments made to total assets based on their riskiness (referred to as the tier-one common equity ratio). Each of these three ratios progressively increases as capital charges are added to deal with selected contingencies. The most stringent risk-based capital ratio shown reaches a potential high of 9.5 percent in 2019.


It may be surprising to many to learn that the eight big banks have already made substantial progress as they race to the 2019 finish line. Indeed, all of the banks are well ahead of schedule. Six of the banks (data are unavailable for Goldman Sachs and Morgan Stanley) already satisfy the U. S. leverage ratio standard. And all of the banks meet the least stringent of the risk-based capital standards and are quite close to meeting the second most stringent standard. As regards the most stringent risk-based capital standard, one of the banks (State Street) has already reached the finish line, while the remaining seven are at least four years ahead of schedule.

In contrast to the bad press weaEUR(TM)ve seen about big banks in recent years, the progress made by these big banks should be good news. To the extent that these new capital standards actually measure the safety and soundness of banks, the likelihood of another banking crisis involving these banks, which account for about two thirds of total U.S. banking assets, would appear to be quite remote. Importantly, even if problems arise, more capital is available to cover more losses, which better protects the deposit insurance fund and ultimately taxpayers.

Not to be overlooked, however, is the downside to increases in capital ratios so far ahead of schedule. As banks shed or even fail to increase total assets (and total loans) to help achieve higher asset-to-capital ratios, less credit is extended to consumers and small businesses. This adverse effect on credit availability can be compounded when banks sell mortgage-backed securities or other risky assets and then keep the proceeds as excess reserves (now totaling $1.5 trillion). This helps to improve risk-based capital ratios as the quantity of risky assets is reduced, but it fails to stimulate the economy through greater credit availability.

Ironically, the government is working against itself: banks are curtailing the availability of credit by taking actions to meet the governmentaEUR(TM)s higher capital requirements, while the government, through the Federal ReserveaEUR(TM)s quantitative easing operations, is pursuing policies to increase the availability of credit.