Do safer banks mean less economic growth?

One reason the financial crisis was so severe was that banks were highly leveraged. That is, they relied heavily on borrowed funds to acquire risky financial assets. This left them highly vulnerable when those assets' prices collapsed and the banks were unable to raise the funds they needed to pay off their loans.

In response, regulators have increased the capital requirements for banks. This limits the amount of leverage they can use and provides a safety buffer against losses. But banks protest that these more stringent capital requirements interfere with their ability to provide the financing the economy needs to function optimally, and hence this will slow economic growth.

However, recent research calls this into question.

Before getting to that research, how do capital requirements limit the amount of leverage banks can use? How is leverage defined?

An analogy will help. When you buy a house, you're usually required to make a down payment, and you finance the rest through a mortgage loan. Assume the house costs $200,000 and the down payment is 10 percent, or $20,000. You'll need a mortgage loan of $180,000 to purchase the house. Therefore, the asset -- the house -- is financed with $20,000 in capital (or equity) and a liability of $180,000.

Leverage is defined as the ratio of the value of the asset to the amount of capital (in addition to equity, capital is also called net worth). In this case, leverage would be $200,000/$20,000 = 10.

As we learned in the housing crisis, the value of a house is risky because it can rise or fall unexpectedly. In this example, as long as the $200,000 house does not lose more than $20,000 in value -- that amount of equity -- the value of the house will still exceed the value of the loan, and the lender is safe (depending on costs to foreclose and resell the property if the borrower defaults).

Thus, the amount of capital invested in the house -- the down payment or owner's equity -- provides a safeguard to the lender against falling home prices. But if the price falls by more than $20,000, the risk rises that the loan won't not get paid off in full if the owner gets into financial difficulty, say, from losing a job.

Notice, however, that if the down payment (or capital requirement) is 20 percent, or $40,000, so that leverage falls to 5 (i.e., $200,000/$40,000), then the lender's safety margin is much larger. Now the price of the house can fall by up to $40,000 before its value is insufficient to cover the value of the loan.

So, a larger capital requirement (down payment) reduces leverage and provides a larger safety margin for the lender.

The story is a bit more complicated for financial institutions, but they operate in much the same way, and the same intuition applies. A commercial bank takes in deposits through checking and saving accounts, which are equivalent to borrowing the money, and then uses those deposits to finance loans and purchase financial assets.

In this case, the assets are loans and securities, and the bank largely finances them through borrowing (checking deposits, savings deposits, issuing CDs, borrowing from other banks on the federal funds market, etc.). The difference between the two, assets minus liabilities, is the bank's net worth (capital).

More generally, financial institutions in the traditional and shadow banking sectors borrow short-term in all sorts of ways and make longer-term loans (or purchase securities with maturities that exceed the term of the loan). This is the equivalent of a homeowner using a series of 30 one-year loans to finance the purchase of a house over a 30-year period. To do this, the homeowner would need to take out a new loan each year to pay off the loan from the year before.

But if the home's price falls too far for some reason, nobody will be willing to lend to the homeowner, who'll then be unable to pay off the loan when it becomes due at the end of the year.

Financial institutions get into trouble the same way.

Prior to the financial crisis, some banks had leverage ratios of 30 or more, meaning the bank's capital was only around 3%. That turned out to be far from a sufficient buffer against the collapse in asset prices that occurred, and this caused many banks to become insolvent.

And insolvency is contagious because when one bank can't pay off its loans, another bank absorbs the losses, and that can cause the second bank to default on its loan payments -- and so on. This can lead to a domino-type collapse of financial institutions.

To make that less likely, regulators have increased the capital requirements for banks, though not as much as many observers believe is needed. Still, banks complain that it will undermine their ability to provide financial services the economy needs.

Which gets us to the new recent research on that topic by Stephen Cecchetti, described in a summary of a policy brief for the Center for Economic Policy Research. It suggests that these worries are overblown. As he notes, the evidence to date suggests that "the predictions that higher capital requirements would drive up interest margins and reduce credit volumes are very clearly at odds with the evidence of smaller spreads and increased lending. Insofar as there was any macroeconomic impact at all, it appears to have been inconsequential."

In fact, Cecchetti believes "We should seriously consider requiring further additions to bank capital, given that the social costs of post-crisis capital increases appear to have been small." Such an increase would make the banking system safer from collapse with little cost to the national economy.