Capital Buffers

• Author: Jihad Dagher, Giovanni Dell’Ariccia, Lev Ratnovski, and Hui Tong

Capital Buffers Finance & Development, September 2016, Vol. 53, No. 3

Jihad Dagher, Giovanni Dell’Ariccia, Lev Ratnovski, and Hui Tong

How much capital banks need is an important public policy question

The recent global financial crisis demonstrated how distressed banks can undermine the real economy that produces goods and services. What started as a financial sector problem—real-estate-related losses at banks and other financial intermediaries—quickly turned into an economy-wide problem, at first in the United States, then in other advanced economies.

The large losses banks incurred stirred fear about their soundness and led to the modern version of a bank run: large uninsured depositors and bank creditors running for the exit (Huang and Ratnovski, 2011). Governments had to inject massive amounts of cash and capital into the banking system to ensure that the institutions had the funds needed to meet their obligations and a big enough buffer to keep them solvent.

Policymakers, economists, and regulators have long grappled with what steps could have been taken before 2007 that would have attenuated or even prevented the crisis—which triggered a global recession whose effects are felt even today. One possible measure would have been to require banks to have more capital.

Why banks need capitalA bank’s capital is the difference between the value of its assets and that of its debt liabilities (including deposits). In other words, it is the portion of the bank’s assets that belongs to its shareholders. A bank’s creditors and depositors are better protected from bank distress when the ratio of capital to total assets is high. There are a number of reasons for this. First, because equity holders are the most junior stakeholders in the bank, capital serves as a buffer that can absorb possible bank losses. Second, because equity holders indirectly control a bank’s behavior, the bank is more likely to invest prudently when they have more at stake.

From an aggregate welfare standpoint, an optimal capital level is one that takes into account the cost and benefit of capital not just to banks but to the overall economy. Market forces provide incentives for banks to maintain a positive level of capital. However, because bank shareholders do not internalize the bad effects a bank’s failure might have on bank creditors, depositors, and the overall economy, they tend to want to hold far less capital than is seen as optimal from the society’s point of view (De Nicolò, Favara, and Ratnovski, 2012). Accordingly, bank capital levels have long been subject to regulations that aim to bring them closer to the social optimum.

Early bank regulation—so-called Basel I, after the Swiss city where the international group of central bankers and bank supervisors...