Bank Capital and Stress Tests: The Foundation of a Thriving Economy

We submitted this statement to the Subcommittee on Financial Institutions and Consumer Credit of the Committee on Financial Services of the U.S. House of Representatives for its hearing on July 17, 2018.

We appreciate the opportunity to submit the following statement on the occasion of the hearing entitled “Examining Capital Regimes for Financial Institutions.” We welcome the Subcommittee’s further examination of the existing regulatory approach for prudentially regulated financial institutions.

We are academic experts in financial regulation with extensive knowledge of the financial industry. Our experience includes working with private sector financial institutions, government agencies and international organizations. In our view, a strong and resilient financial system is an essential foundation of a thriving economy. The welfare of every modern society depends on it. The bedrock of this foundation is that banks’ capital buffers are sufficient to withstand significant stress without recourse to public funds. Furthermore, it is our considered view that the benefits of raising U.S. capital requirements from their current modest levels clearly outweigh the costs.

To explain this conclusion, we start with a definition of bank capital, including a discussion of its importance as a mechanism for self-insurance. We then turn to capital regulation and a discussion of stress testing.

What is bank capital? There are several consistent definitions of a bank’s capital (or, equivalently, its net worth). First, capital is the residual that remains after subtracting a bank’s fixed liabilities from its assets. Second, it is what is owed to the banks’ owners—its shareholders—after liquidating all the assets. Third, it is the buffer that separates the bank from insolvency: the point at which its liabilities exceed the value of assets.

Importantly, capital is a source of funds that the bank uses to acquire assets. This means that, if a bank were to issue an extra dollar worth of equity or retain an additional dollar of earnings, it can use this to increase its holding of cash, securities, loans, or any other asset. Put differently, equity is not a wasted resource. When a bank finances additional assets with capital, its ratio of equity to total assets—the leverage ratio—rises.

Banks (and many other financial intermediaries) finance their assets with a far larger proportion of debt (relative to equity) than nonfinancial firms. Recent data show that nonfinancial firms typically issue between $0.80 and $1.50 worth of debt for each dollar of equity, implying a leverage ratio of 40 to 55 percent (see here and here). By contrast, the largest banks in the United States issue an average of roughly $14 in debt for each dollar of equity. That is, the eight global systemically important U.S. banks (G-SIBS) have a leverage ratio of roughly 7 percent. This high reliance on debt boosts both the expected return on and the riskiness of bank equity, and makes banks vulnerable to even moderately adverse events.

Role of bank capital. Bank capital acts as self-insurance, providing a buffer against insolvency and, so long as it is sufficiently positive, giving bank management an incentive to manage risk prudently. Standard automobile insurance creates a similar incentive: auto owners bear part of the risk of accidents through deductibles and co-pays, which also motivate them to keep their vehicles road-ready and to drive safely.

When capital is too low relative to assets, however, bank managers have an incentive to take risk. The reason is straightforward. Shareholders’ downside loss is limited to their initial investment, while their upside opportunity is unlimited. As capital deteriorates, potential further losses shrink, but possible gains do not. Because shareholders face a one-way bet, they will encourage bank managers to gamble for redemption. They also will discourage managers from issuing more equity, because that would dilute the value of existing shares, while the primary benefit would accrue to debtholders through reduced risk of bankruptcy. This incentive problem goes away as the level of capital rises. That is, when shareholders have more skin in the game, exposing them to greater losses, bank managers will be encouraged to act more prudently. (See Myers' discussion of the debt overhang problem.)

Finally, a banking system that is short of capital can damage the broader economy in three ways. First, an undercapitalized bank is less able to supply credit to healthy borrowers. Second, weak banks may evergreen loans to zombie firms, adding unpaid interest to a loan’s principal and further undermining their already weak capital position to avoid the realization of losses. Finally, in the presence of an aggregate capital shortfall in the banking system, the system as a whole is more vulnerable to contagion and panic. Even a small spark can ignite such dry and fragile tinder.

Capital requirements. Minimum capital requirements are the leading regulatory tool for ensuring the resilience of banks (and bank-like intermediaries). In addition, regulators use stress tests to limit concealed leverage and to measure the capital adequacy of banks in adverse scenarios where asset prices are assumed to plunge precipitously, markets cease to operate and funding evaporates. The combination of higher capital requirements and rigorous stress tests has led to a welcome rise in banking system capital in the decade since the financial crisis. But, how much capital is enough?

If we let the banks choose, they typically minimize reliance on equity funding, which they perceive as expensive. That is, raising capital requirements will raise a bank’s private costs. But, to the extent that higher capital requirements compensate for banks’ ability to conceal risk and reduce the distortions from public subsidies that come through the government safety net, social cost will decline. As one indicator of the scale of public support, the Federal Reserve Bank of Richmond estimates that 60 percent of the liabilities of the U.S. financial system are protected by the safety net.

However, there is a clear drawback to raising bank capital requirements. Because banks view equity financing as expensive, higher requirements encourage a shift of risk-taking to non-banks—beyond the regulatory perimeter. As we discuss in an earlier post, one solution to this is to focus regulation on the economic function rather than the legal form of an intermediary. Absent such activities-based regulation, there will be a point where higher capital requirements, while making banks more resilient, will make the financial system less safe because of risk shifting (i.e. regulatory arbitrage).

Estimating the appropriate level for capital requirements requires balancing the benefits and the costs. In principle, this is straightforward. Larger capital buffers reduce both the frequency and severity of financial crises. But this improved resilience comes at the cost of reduced levels of lending. And, since credit fuels economic activity, growth may be lower. What level of capital equates social benefits and costs?

There is a range of views. At the top end, proponents of narrow banking call for all risky assets to be 100 percent financed by equity. Others advocate a leverage ratio in the range of 15 to 30 percent. (See Admati and Hellwig, Dagher et al. and the Minneapolis Plan.) The CHOICE Act proposed 10 percent as a threshold for exempting banks from strict scrutiny (see here). Notably, all these proposals far exceed current capital requirements, which are in the range of 3 to 6 percent. In contrast, the Treasury argued in June 2017 that capital requirements for the largest U.S. banks should be “recalibrated” in cases where they exceed international standards.

Our view is that requirements should be strengthened, not weakened. We base our conclusion on a number of facts. First, banks’ increased reliance on equity funding over the past decade has not diminished the supply of credit. Bank capital requirements (measured on a consistent risk-weighted basis) have gone up by at least a factor of 10. Furthermore, capital ratios today are several times higher than they were before the crisis. Yet, relative to GDP, commercial bank credit remains robust, having surpassed its pre-crisis peak (see here).

Second, strong banks lend to healthy borrowers, weak banks don’t! This conclusion is based on the simple observation that countries with better capitalized banking systems in 2006, prior to the start of the crisis, experienced stronger lending growth during and after the crisis. Not only that, but decades of experience in Japan (and more recent activity in the euro area) show that poorly capitalized banks tend to evergreen loans―increasing loan principal to include unpaid interest from non-performing loans. As we describe in a previous post, in their zeal to avoid recognizing loan losses, zombie banks lend to zombie firms.

Third, higher bank capital levels are associated with higher share prices. Investors at least partly reward banks in jurisdictions where regulators and supervisors promote social welfare through tougher capital standards. As a result, the private cost of imposing socially optimal capital requirements may be smaller than critics fear (see our earlier post).

While we cannot say precisely how much higher capital requirements should be, our recommendation is that authorities gradually raise them at least until we see some of the claimed detrimental side effects—namely, a diminished supply of credit to healthy borrowers, a shift of risk-taking to bank-like intermediaries beyond the regulatory perimeter, or both.

Stress tests. It is notoriously difficult to measure the size of a capital buffer. How risky are assets? What are the consequences of off-balance sheet exposures? What portion of capital is truly loss-absorbing when a severely adverse shock hits? What will happen to capital levels in the event of a severe recession that causes widespread distress? We can use stress tests to answer these questions.

Today, these tests have three primary objectives: guaranteeing that banks have rigorous internal risk management processes; ensuring that banks’ management and boards of directors are attentive to the risks their enterprises face; and providing the authorities with a comprehensive map of the risks and vulnerabilities in the financial system. (For a discussion of the history and uses of stress testing, see here.) 

We can summarize any stress testing regime by measuring three of its attributes: transparency, flexibility and severity. The mix of these characteristics determines the regime’s effectiveness.

To understand the tradeoffs and pitfalls, consider the case of Fannie Mae and Freddie Mac, the government-sponsored mortgage lenders (the GSEs). As Frame et al. describe, unlike banks, the GSEs were subject to an annual government stress test before the financial crisis. Following a decade of development, the Office of Federal Housing Enterprise Oversight (OFHEO) began conducting tests in 2001. The GSEs always passed—until they collapsed at the height of the crisis in September 2008.  We can trace the ineffectiveness of these early stress tests to their mix of transparency, flexibility and severity. First, there was complete transparency: OFHEO published the models and scenarios in the Federal Register prior to initiating the tests. Second, there was no flexibility: from year to year, neither the parameters nor the macroeconomic conditions changed. And third, the stress applied was insufficiently severe: house prices rose for the first 10 quarters of the scenario, before falling only modestly over the full 8-year horizon.

Is any of these three dimensions (transparency, flexibility and severity) more critical than the others? The answer is yes. First, if the scenarios are insufficiently dire, there is no point to the test. Second, flexibility is essential. Without it, the tests are useless. Third, there is considerable room for transparency, but there are limits. Because models change slowly, and banks can glean considerable information about the Fed’s models from past tests, disclosure of these models is unlikely to be a problem. Premature disclosure of the scenarios is another matter: in contrast to the GSE tests, and in line with the Fed’s current Comprehensive Capital Analysis and Review (CCAR) practice, scenarios should change frequently with disclosure only after the banks’ portfolios are determined. The alternative invites gaming (see our discussion here).

In our view, the Federal Reserve has developed a broadly effective framework for carrying out its all-important stress tests of the largest U.S. banks. Yet, having started in 2011, the Fed has now completed only the seventh CCAR exercise. That means that everyone is still learning how to best structure and execute the tests.

With this same goal in mind, we make the following proposals for enhancing the stress tests and preserving their effectiveness:

  1. Change the scenarios more aggressively and unexpectedly, continuing to disclose them only after banks’ fix their balance sheet (and off-balance sheet) exposures.
  2. Introduce an experimental scenario (that will not be used in “grading” the bank’s relative performance or capital plans) to assess the implications of events outside of historical experience and to probe for weaknesses in the financial system.
  3. As a way to evaluate banks’ internal models, require publication of loss rates or risk-weighted assets (RWA) for a range of hypothetical portfolios.
  4. Stick with the annual CCAR cycle.

Finally, in line with the goals of the Dodd-Frank Act and the recent Economic Growth, Regulatory Reform and Consumer Protection Act (EGRRCPA), regulators should tailor capital and other regulatory requirements, including stress tests, to the riskiness of financial institutions. Having fewer than $10 billion in assets, the vast majority (5,474 out of 5,606) of U.S. depositories pose virtually no risk to the system. For these relatively small institutions, the self-insurance requirements should aim primarily at avoiding taxpayer losses through deposit insurance. At the other end of the size spectrum, the U.S. G-SIBs, scale serves as a reasonable proxy for the risks to the financial system.

However, for the two dozen or so medium-sized institutions with assets from $100 billion to $250 billion, scale alone is a poor indicator of risk. The EGRRCPA raised the asset threshold for strict regulatory scrutiny from $50 billion to $250 billion, but left the Federal Reserve with an option to maintain close oversight for those banks with at least $100 billion in assets. As we explain in an earlier post, to improve risk-management incentives for these banks, and to limit legal disputes with the Federal Reserve, it would be better to flip the legal default by allowing the central bank the option to exempt those medium-sized banks that demonstrate their safety using an agreed-upon array of risk indicators.

Conclusion. Our conclusions are clear. First, U.S. regulators should consider raising capital requirements significantly further, albeit at a gradual pace. Second, ensure that stress tests remain flexible and stressful.

We close with a quote from Sir Paul Tucker, Chair of The Systemic Risk Council and former Deputy Governor of the Bank of England:

“The history of bank regulation in the United States is of progressive dilutions of core regulatory requirements over a number of years, leaving the banking system as a whole vulnerable to crisis.”

We hope that the Congress and the federal agencies to which it has delegated authority for financial regulation and supervision take this experience to heart, remaining diligent in protecting the public interest.