Debt causes fragility. When banks lack equity funding, even a small adverse shock can put the financial system at risk. Fire sales can undermine the supply of credit to healthy firms, precipitating a decline in economic activity. The failure of key institutions can threaten the payments system. Authorities naturally respond by increasing required levels of equity finance, ensuring that intermediaries can weather severe conditions without damaging others.
Readers of this blog know that we are strong supporters of higher capital requirements: if forced to pick a number, we might choose a leverage ratio requirement in the range of 15% of total exposure (see here), roughly twice recent levels for the largest U.S. banks. But as socially desirable as high levels of equity finance might be, the fact is that they are privately costly. As a result, rather than limit threats to the financial system, higher capital requirements for banks may shift risky activities beyond the regulatory perimeter into non-bank intermediaries (see, for example here).
Has the increase of capital requirements since the financial crisis pushed risk-taking beyond the regulated banking system? So far, the answer is no. However, in some jurisdictions, especially the United States, the framework for containing systemic risk arising from non-bank financial institutions remains inadequate.
Over the past decade, both bank capital requirements and bank equity financing have risen significantly. As we explain in a previous post, accounting for changes in definitions and coverage, Basel III represents a roughly 10-fold increase in required capital. Looking at recent data, we see that, for the largest banks in the world, capital levels are up significantly―by 3 percentage points of exposure on an unweighted basis (the dashed red line), and by more than 7 percentage points of assets on a risk-weighted basis (the solid black line). (For a general discussion of the role of bank capital, see our primer; and for a discussion of the final Basel III standard, see here.)
Capital ratios using Basel III definitions, 2009-17
We have written about this increase in bank equity finance on a number of occasions, concluding that there are few if any harmful side effects. In our view, higher capital requirements have little impact on economic growth (see here). If anything, they are associated with increases in both the quantity and quality of bank lending (see here). And, despite rising levels of capital, U.S. banks’ return on equity (ROE) have steadied above 8% after 2011, and climbed above 12% following the 2018 corporate tax cut. (For euro-area banks, ROE is around 6%.) Finally, as we discuss, banks that rely more on equity finance have higher price-to-book ratios, suggesting that investors reward them for prudently managing risk.
So, if we focus solely on banks, the financial system clearly looks safer than a decade ago. But what about non-bank finance? Have higher capital requirements driven banking activity beyond the regulatory perimeter? To see, we can look at the Financial Stability Board’s most recent monitoring report. The following chart shows the composition and scale of intermediation worldwide.
Financial system assets by sector (percent of total), 2007-17
Our reading of these data is that from 2007 to 2017, as overall intermediation (measured by total assets) rose by two thirds to $333 trillion, banks became somewhat less important, with their share of global declining from 48% to 44% (the gray bars). Meanwhile, non-bank intermediaries’ share of total financial system assets increased from 31% to 36% (the yellow bars). So, it does appear that a shift is taking place.
Yet, a closer look across jurisdictions suggests no obvious link between higher worldwide capital requirements and the shift of intermediation toward non-banks. In the United States, where bank capital levels increased disproportionately over the decade ending 2017, banks’ share of intermediation rose—from 22% to 25%. Something similar happened in Canada and the United Kingdom, with banks’ shares rising from 27% to 30% and 54% to 56%, respectively. By contrast, the euro area looks completely different. There, banks had accounted for 60% of intermediation prior to the crisis. By 2017, despite capital ratios that lag U.S. norms, banks’ role in intermediation plunged: by 2017, euro-area banks accounted for just over 40% of total intermediation. To put some absolute figures to that, from 2007 to 2017, total euro-area intermediation rose from $58.2 trillion to $93.4 trillion―a nominal increase of 60%. Yet, euro-area bank assets stagnated, edging up by 3% from $33.7 trillion to $34.8 trillion. Once again, if anything, the evidence suggests that less well-capitalized intermediaries are less willing or less able to supply credit.
How closely are banks and non-banks linked in the financial system? Put differently, if a shock hits one group, how likely is it to be transmitted and amplified across the system? Answering that question requires a great deal of information about financial networks and the connections among key intermediaries (including specialized institutions, such as central clearing parties). The FSB’s monitoring report contains one piece of relevant information: the extent to which banks and non-banks hold each other’s liabilities. These exposures can take the form of loans, deposits or securities. The following simple chart tells the story: measured in this way, interconnectedness has fallen. In 2007, 6.9% of bank assets represented funding to non-banks. By 2017, that share fell to 5.5%. Meanwhile, non-banks’ exposure to banks fell by even more, from 8.4% to 6.3%.
Mutual exposures of banks and nonbanks (percent of assets), 2007-17
So, here are the facts:
Capital requirements and bank capital buffers are far higher than they were a decade ago. (They also have additional loss-absorbing debt that may make bailouts less likely.)
Since 2007, financial intermediation around the world grew by more than 50%, and now stands at about $330 trillion.
Overall, banks’ share of both total intermediation and provision of credit fell modestly, while the importance of non-banks has risen somewhat.
Geographically, regions with disproportionately higher bank capital requirements and capital levels did not experience shifts of intermediation beyond the regulatory perimeter.
Interconnectedness, measured by the banks and non-banks exposure to one another, has fallen.
All of this leads us to conclude that, while the system is safer, the costs of raising capital requirements gradually further seems quite limited, while the benefits remain significant.
Indeed, at this advanced stage of the business cycle expansion, with real interest rates still barely positive, intermediaries of all kinds have the incentive to take risk in the provision of credit. So far, they appear to have been cautious. Yet, while the overall share of non-bank intermediation is up only modestly, some types of risky intermediation are dramatically larger. One example is leveraged lending―provision of loans to sub-investment-grade borrowers who are already highly indebted, and hence have a relatively high risk of default. According to the Bank of England’s recent Financial Stability Report, securitization has boosted the supply of leveraged loans back up to the very high level of 2007. Furthermore, banks hold roughly one-third of the resulting collateralized debt obligations (see charts F.1 and F.8 here). This, and other activities like it, bear further monitoring and assessment.
For us, the lesson is two-fold. First, continue to ensure that if something does go awry elsewhere, banks have sufficient capital to withstand the shock. Second, remain on the lookout for problems outside the regulatory perimeter. This means that we need a clear framework to monitor, assess, designate, regulate and supervise non-bank intermediaries across the global financial system.
For now, different jurisdictions are addressing this surveillance and supervisory challenge in very different ways. In the U.S. process, the regulatory framework— with more than 150 federal and state agencies—is “riddled with regulatory gaps, loopholes and inefficiencies.” In addressing banks and non-banks, it focuses typically on legal form, rather than economic function. Within this byzantine framework, the Office of Financial Research has the task of collecting information, monitoring the financial system, and then providing assessments to the Financial System Oversight Council (FSOC). FSOC can then designate specific non-bank institutions for strict prudential supervision or encourage regulatory agencies to limit risky activities within their mandate. Yet, following FSOC’s decisions to de-designate all nonbank SIFIs, and lacking any specifics regarding Treasury’s stated preference for regulating activities over entities (see page 7 here), this process seems deeply ineffective (see our discussions here and here)
The contrast with the U.K. system could not be starker. There, financial institution regulation (both micro- and macro-prudential) is concentrated in the Bank of England, with the Financial Conduct Authority responsible for market regulation, consumer protection and competition policy. That is, there are only two agencies involved. Moreover, there is an agreed process for expanding the regulatory perimeter. After determining that it is appropriate to bring an instrument or entity under its umbrella, the Bank of England can make a request to Her Majesty’s Treasury. Once the Treasury agrees, they then take the proposal to the U.K. Parliament and request the necessary authority, which would normally be forthcoming.
The message is that we need a transparent regulatory framework that is capable of being clear-eyed and vigilant. There is no reason to chase every financial innovation as if it is going to create the next crisis. A few new instruments, institutions and mechanisms may add greatly to welfare; many will languish; and most are harmless. Only those risky activities that grow large—at least relative to the capitalization of leveraged intermediaries—become salient for the financial system as a whole, and only a subset of these will pose serious systemic risks. But we need to be watching because one day something will start happening that, if left unchecked, will again threaten broad financial disruption.