The Wall Street Journal published an article today titled “Stronger Banking System Could Lessen Need for Unconventional Monetary Policies.” The article links the findings of two recent academic papers on bank regulation to come to the conclusion summarized in the title. First, Hyun Song Shin, chief economist at the Bank for International Settlements, found that a banking system that is better capitalized extends more credit and supports more economic growth. And second, former Treasury Secretary Lawrence Summers and fellow Harvard professor Natasha Sarin, found that, by market measures, banks are no better capitalized than they were before the crisis.
We find ourselves in the strange position of agreeing with the central points of each of the papers, and even the title of the Journal article, but nevertheless, on a broader level, being in complete disagreement with the Journal. We read the arguments of the authors in the opposite order. First, as we discuss in another TCH blog post released today, the central point of Summers and Sarin is that the market-to-book values of banks are lower now than before the crisis in part because investors have understandably shifted up their view of the inherent riskiness of the financial system in the wake of the financial crisis, but also because banks’ franchise values have been reduced by a much tighter and uncertain regulatory environment. As Shin points out, in line with William Brainard and James Tobin’s insight into what determines capital investment, when a firm’s market-to-book ratio is lower, the firm has less incentive to expand; in the case of a bank, the bank has less incentive to increase its loan book. Shin also observes that earnings are the main way that banks build up the capital necessary to lend.
So far so good, but where we part ways is that we think it is important to distinguish between the impact of banks having more capital and the impact of requiring banks to have more capital. Indeed, whereas Shin found that bank credit grows 0.6 percentage points a year faster if banks have 1 percentage point more capital, a recent paper by two economists at the Federal Reserve Board (Seung Jung Lee and Viktors Stebunovs), finds that raising bank capital requirements by 1 percentage point reduces employment growth by 0.6 percentage points. While these two results seem contradictory, the resolution is that banks make their lending decisions in part in response to the difference between the amount of capital they have and the amount they are required to have. Indeed, that was precisely the point made by Mark Carney, governor of the Bank of England, when the BoE recently lowered its countercyclical capital buffer. Gov. Carney observed that the reduced capital requirement would allow banks to extend nearly $200 billion in additional loans.
So while we completely agree that stronger banks will support the economy and make unconventional monetary policy less likely, we think the best way to get stronger banks is to foster a stable regulatory environment that allows socially beneficial, prudent risk taking and entrepreneurial activity by banks. Ever tighter, redundant, and constantly changing regulations will likely have the opposite effect. Indeed, a recent workgroup of central bankers convened by the BIS found that the material tightening in bank regulations that occurred after the financial crisis, while appropriate, would reduce the effectiveness of conventional monetary policy measures. The report (p. 39) reaches the opposite conclusion of the Journal, in particular, the BIS workgroup concludes that “As a result, central banks may need to increase their use of unconventional measures when seeking to stimulate aggregate demand.”