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….

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Understanding Bank Capital: A Primer

Over the past 40 years, U.S. capital markets have grown much faster than banks, so that banks’ share of credit to the private nonfinancial sector has dropped from 55% to 34% (see BIS statistics here).  Nevertheless, banks remain a critical part of the financial system. They operate the payments system, supply credit, and serve as agents and catalysts for a wide range of other financial transactions. As a result, their well-being remains a key concern. A resilient banking system is, above all, one that has sufficient capital to weather the loan defaults and declines in asset values that will inevitably come.

In this primer, we explain the nature of bank capital, highlighting its role as a form of self-insurance providing both a buffer against unforeseen losses and an incentive to manage risk-taking. We describe some of the challenges in measuring capital and briefly discuss a range of approaches for setting capital requirements. While we do not know the optimal level of capital that banks (or other intermediaries) should be required to hold, we suggest a practical approach for setting requirements that would promote the safety of the financial system without diminishing its efficiency....

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Moral Hazard: A Primer

The term moral hazard originated in the insurance business. It was a reference to the need for insurers to assess the integrity of their customers. When modern economists got ahold of the term, the meaning changed. Instead of making judgments about a person’s character, the focus shifted to incentives. For example, a fire insurance policy might limit the motivation to install sprinklers while a generous automobile insurance policy might encourage reckless driving. Then there is Kenneth Arrow’s original example of moral hazard: health insurance fosters overtreatment by doctors. Employment arrangements suffer from moral hazard, too: will you shirk unpleasant tasks at work if you’re sure to receive your paycheck anyway?

Moral hazard arises when we cannot costlessly observe people’s actions and so cannot judge (without costly monitoring) whether a poor outcome reflects poor fortune or poor effort. Like its close relative, adverse selection, moral hazard arises because two parties to a transaction have different information. This information asymmetry manifests itself in two ways. Where adverse selection is about hidden attributes, affecting a transaction before it occurs, moral hazard is about hidden actions that have an impact after making an arrangement.

In this post, we provide a brief introduction to the concept of moral hazard, focusing on how various aspects of the financial system are designed to mitigate the challenges it causes....

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