The Right Balance for Banks: Theory and Evidence on Optimal Capital Requirements

by William Cline

Overview

The global financial crisis produced an important agreement among regulators in 2010–11 to raise capital requirements for banks to protect them from insolvency in the event of another emergency. In this book, William R. Cline, a leading expert on the global financial system, employs sophisticated economic models to analyze whether these reforms, embodied in the Third Basel Accord, have gone far enough. He calculates how much higher bank capital reduces the risk of banking crises, providing a benefit to the economy. On the cost side, he estimates how much higher capital requirements raise the lending rate facing firms, reducing investment in plant and equipment and thus reducing output in the economy. Applying a plausible range of parameters, Cline arrives at estimates for the optimal level of equity capital relative to total bank assets. This study also challenges the recent "too much finance" literature, which holds that in advanced countries banking sectors are already too large and are curbing growth.

Product Details

ISBN-13:	9780881327212
Publisher:	Peterson Institute for International Economics
Publication date:	05/23/2017
Series:	Policy Analyses in International Economics , #107
Pages:	175
Product dimensions:	8.90(w) x 5.90(h) x 0.80(d)
Age Range:	18 Years

About the Author

William R. Cline has been a senior fellow at the Peterson Institute for International Economics since 1981. Durgaing 1996–2001, Cline was deputy managing director and chief economist of the Institute of International Finance in Washington, DC. From 2002 through 2011, he held a joint appointment with the Peterson Institute and the Center for Global Development, where he is currently senior fellow emeritus.

Table of Contents

Preface ix

Acknowledgments xiii

1 Overview 1

Plan of the Study and Principal Findings 3

Framing Issues 12

Conclusion 19

2 A Survey of Literature on Optimal Capital Requirements for Banks 21

Heuristic and Seawall Studies 22

Calibrated Optimization 28

Overview 38

Appendix 2A Literature on Transient and Dynamic Stochastic General Equilibrium (DSGE) Estimates 41

3 Testing the Modigliani-Miller Theorem of Capital Structure Irrelevance for Banks 53

Is Banking Special? 55

Capital Assets Pricing Model Betas versus Direct Estimation 57

Arbitrage versus Optimization 59

Specifying the Tests 59

Data 60

Test Results 65

Implications for the Average Cost of Capital 66

Lower Borrowing Cost for Banks? 69

Conclusion 70

Appendix 3A The Modigliani-Miller Model 71

Appendix 3B Demonstrating Constant Average Cost of Capital in Modigliani and Millet 75

Appendix 3C Alternative Analyses of the Modigliani-Miller Offset for Banks 77

Appendix 3D Trends in Unconstrained Earnings Indicators of the Cost of Equity Capital 83

Appendix 3E Possible Endogeneity Bias 85

4 Benefits and Costs of Higher Capital Requirements for Banks 87

Benefits of Higher Capital Requirements 88

Costs of Higher Capital Requirements 103

Optimal Capital Requirements 108

Results 110

Comparison with Other Estimates 114

Implications for Regulatory Capital 116

Further Considerations 118

Conclusion 121

Appendix 4A An Evaluation of the Minneapolis Plan to End Too Big to Fail 123

5 Total Loss-Absorbing Capacity for Large Banks 133

Survey of the Literature on Total Loss-Absorbing Capacity 134

Evidence on US Banks in the Great Recession 151

Share of the Largest Banks in the United States and Other Countries 154

Bank Resolution and Crisis Management 157

Conclusion 162

Appendix 5A Systemic Implications of Problems at a Major European Bank 165

6 A Critical Evaluation of the "Too Much Finance" Literature 177

Too Many Doctors? Too Many Telephones? Too Much R&D? 179

Demonstrating the Bias Toward Negative Quadratic Effects 181

Too Much "Too Much Finance" to Believe? 182

The Cournède-Denk Results 185

Reestimating the Impact of Private Credit 187

Conclusion 194

Appendix 6A Spurious Negative Quadratic Influence in Estimation Based on Related Linear Equations 197

Appendix 6B Description of the Data 199

Appendix 6C Reply to Arcand, Berkes, and Panizza 201

7 Conclusions and Policy Implications 205

Summary of Empirical Results 207

Implications for Basel Targets 209

Other Key Policy Issues 212

References 217

Index 229

Tables

2.1 Literature estimates of optimal ratio of capital to risk-weighted assets 39

3.1 Impact of raising the capital-to-assets ratio from 10 to 25 percent 67

4.1 Estimates of output losses from banking crises in advanced industrial countries, 1977-2015 92

4.2 BCBS synthesis of impact of capital on the probability of systemic banking crises 100

4.3 Alternative parameter values for simulations 105

4.4 Other parameter and base values 105

4.5 Basel III and FSB capital requirements for G-SIBs 117

5.1 Indicators of relative impact of the Great Recession on largest banks compared with medium-sized banks in the United States 153

5A.1 Ratio of share price to book value for global systemically important banks (G-SIBs) in Europe and the United States, October 26, 2016 170

6.1 Cournède and Denk estimates for three specifications of regressions for per capita GDP growth 185

6.2 Cline estimates for four specifications of regressions for per capita GDP growth 190

6.3 Growth results for low versus high financial depth 192

Figures

3.1 Net income relative to equity, earnings yield, and debt to equity ratio, averages for the 54 largest US banks: Constrained data, 2002-13 63

3.2 Distribution of annual bank net incomes relative to assets, 54 largest US banks, 2002-13 64

3C.1 Bank lending rates in the United States and euro area, 2001-15 78

3D.1 Net income relative to equity and earnings yield averages for the 54 largest US banks: Unconstrained data, 2002-13 83

3E.1 Relationship of unit cost of equity to debt-to-equity ratio 85

4.1 Losses from a banking crisis 90

4.2 Benefits of additional bank capital 102

4.3 Benefits and costs of additional bank capital 111

4.4 Frequency of estimates for optimal capital-to-assets ratio 112

Editorial Reviews

Cline...concludes from both a careful review of the literature and his own cost-benefit analysis that capital levels should be even higher.

Daniel K. Tarullo

This book is a significant addition to the literature on optimal capital estimation, and should engage the attention of the Basel Committee and regulators.

Central Banking