There’s an old adage about banking that’s seemingly as old as banking, and it goes like this: for a well-run bank any capital requirement (no matter how small) is way too high, and for a poorly run bank, no capital requirement is high enough. It’s something for regulators to think about now.
In the aftermath of troubles at Silicon Valley Bank (SVB), regulators have predictably happened upon increased capital requirements as the alleged banking fix. At best these more stringent rules will weaken banks, and at worst they’ll imperil banking stability.
To see why, it’s worth remembering that banks don’t pay interest on deposits so that they can stare lovingly at the money. They do so in order to lend the money out at a higher rate of interest. Capital requirements explicitly limit profitable activity engaged in by banks, thus limiting profits overall. Stop and think about this.
Banks “rent” funds from savers so that they can carefully lend the money out at a higher rate. Carefully is crucial here. Since banks make money off of the spread between interest paid on deposits and interest paid on the loans they originate, they need their loans to perform. One bad loan can erase 99 good ones. This is important to keep in mind with the soundness of bank loans top of mind.
That’s the case because regulator-enforced capital cushions specifically sideline a little or a lot of bank capital. This means that banks, while paying interest on all the monies in their control, can only pursue profitable activity with a smaller amount of money than they perhaps otherwise would. Regulators explain capital requirements as a way of protecting banks from unexpectedly rainy days, but rules that limit lending arguably make the rainy days more likely as banks perhaps more aggressively put available funds to work in order to make up for the income lost by the capital requirements.
From there, let’s not forget that the same regulators arrogating to themselves the right to dictate how much money banks keep in reserve have also ascribed to themselves the right to decide the makeup of those reserves. This is no small thing, and SVB’s troubles explain why. As opposed to SVB swinging for the proverbial fence with depositor money, it mostly bought reasonably short-duration Treasuries. For largely doing as regulators desired, SVB’s reward was a bank run.
To which some will say that SVB should have seen the direction the Fed was going on interest rates, only to further shrink the duration of the assets on its books. This all-knowing advice fails twice. For one, if foresight was as obvious as hindsight then logic dictates that SVB altering its portfolio for alleged central bank inevitability would have been like buying fire insurance as the fire burned. Second, divining the direction of interest rates is no easy feat. As evidenced by how much money macro traders can earn by knowing the future direction of rates, they’re far more mysterious than the Monday Morning Quarterbacks in our midst naively imagine them to be.
It all confirms that the best answer for regulators is to leave banks alone. Increased capital requirements will as mentioned weaken the best banks, and they plainly won’t be enough for the bad ones. Which is in a very real sense ideal for the health of the banking sector in general. Rather than foisting profit-sapping rules on banks, how about regulators allow markets to work, including market forces that will allow the best banks to purchase the ones for whom no capital cushion will ever be enough?
