The biggest danger facing banks today is that they will be asked to hold too much capital. Regulators have seized upon a lack of capital as a fundamental cause of the crisis and are now busy seeking its greater application in every part of the business. The worry is that they will become over-zealous and hobble future growth.
Capital levels certainly need to be reviewed, but care must be taken in assuming that every problem can be solved by simply holding greater amounts.
One of the lynchpins of capitalism is fractional reserve banking. The key word in that term is 'fractional'. By lending out funds greater than those that they hold (and at different maturities to the deposits), banks can provide credit far more widely than if they were fully reserved. But it clearly involves risk. In making banks safe, will regulators also make them ineffective?
In the UK, one analyst has calculated that if all the various proposals on the table were to come to fruition, the Tier 1 capital ratio could reach 11%. A banking system with a capital ratio that size would be an entirely different proposition to the one that currently exists.
Capital sources
This new capital is likely to come in several forms. Trading is a key area for concern and rating agency Fitch estimates that under new Basel proposals capital levels could rise up to five times for banks using internal risk-management models. European bankers are doing their best to fend off these new trading book charges that would come down to them in the form of the proposed EU Capital Requirements Directive 3.
Other areas for applying more capital are obviously securitisations, especially where there is extra complexity; in provisioning where an argument is being made for applying capital when loans are made rather than when they default; and in hybrid capital where the trend is towards contingent capital (or CoCo) which converts to shares if Tier 1 capital falls below 5%.
No doubt all of these suggestions are good ideas, but if they are landed on banks at once, the total effect may be to slow down lending, and economic growth, in unintended ways.
