US President Donald Trump’s executive order calling for roll-back of rules introduced after the 2007-09 financial crisis has sparked fears that the world’s most influential financial market would retreat from global rulemaking. To add fuel to it, treasury secretary Steven Mnuchin last week said that the US would continue to engage in global rulemaking, but would do so in a way that helps Wall Street be globally competitive. This posturing by the US comes days before the Basel Committee and the Financial Stability Board is to convene in Washington.
I am not surprised that the US President thinks that the new international bank capital rules are anti-American. Anything remotely inconvenient to him or to his political agenda, from Facebook to Amazon, he conveniently labels them as anti-American. In Trump’s post-factual politics, the world’s most influential economy’s policy is framed largely by what appeals to jingoistic emotions of Trump’s voter base rather than for the greater good of the economy.
A mandatory increase in bank capital under the new regulatory regime has made the Wall Street’s profits and shoulders droop, but I am not sure if it is anti-American. Wall Street CEOs are lamenting that their banks’ return on equity would decline under the new banking rules. Therefore, despite knowing that more bank capital is valuable for larger global banking sector stability including that of the US, they lobby furiously against increased equity requirements with the country’s lawmakers. They conveniently ignore, or choose to ignore, the fact that lower return on equity is happening simultaneously with decreased leverage. Increase in equity decreases leverage, which, in turn, decreases the risk for the bank. Return on equity is meaningless without accounting for the risk, which depends critically on leverage.
In 2008, the fallout from the high leverage that banks had, had devastated the American economy. But those facts can be conveniently ignored because, in Trump’s post-truth politics, emotions and jingoism trumps economic policy.
Assertions that increased equity requirements would restrict lending and growth are based on flawed arguments that seek to deliberately mislead. Lending decisions will be improved with more equity funding—if banks have more skin in the game, they will be more judicious in lending. The subprime crisis owed in part to lax lending decisions. It is too much leverage and not too much equity that causes credit crunches. Stricter capital adequacy requirements would avoid costly potential bailouts using taxpayers’ money.
Increasing bank capital would be painful for the Wall Street in the short run, but there would be significant gains to the broader economy from a healthier and more stable financial system. Economies can grow and prosper with safer, less complex banks that deliver better value overall to the economy.
Bank capital is often misunderstood and can be used to mislead legislatures who are rarely economists or bankers. It is misconstrued because it is often thought of as a pile of money that banks must hold in reserve or set aside passively, which is not the case. Bank capital is about how is money sourced rather than how it is used by the bank for various activities, including lending. This is different from reserve or liquidity requirements like CRR and SLR, which concern how funds are deployed. For instance, in India, where CRR and SLR are 4% and 20%, respectively, if a bank raises a deposit of Rs 100, it has to park Rs 4 with RBI as cash reserve requirement. Similarly, it has to invest in liquid instruments like Government of India Securities for Rs 20 as statutory liquidity requirement. It has to thus set aside Rs 24 and will be able to use only `76 for lending and other investment purposes. However, bank capital is not about funds deployment, but about funds sourcing. If the bank puts in Rs 10 of its own money, no part of it has to be set aside for meeting CRR or SLR requirements. It might lend Rs 80—`70 of which comes from depositors and `10 from the bank. Its capital adequacy is 12.5% (=`10/`80). The `10 that the bank puts into the business is sourced in the form of equity of around Rs 7 and Rs 3 of long-term bonds issued by the bank.
President Trump is understandably concerned about US banks’ profitability, if not for greater American good, but at least for greater Wall Street’s good. Under the earlier Basel-II regime, the source of funds for banks had to be around Rs 5 of equity and Rs 3 from long-term bonds. Now, with the new Basel regulations, the equity might increase to about Rs 10. If the bank had earnings of Rs 1, the return of equity earlier would have been 20% (`1 on an investment of Rs 5), which now would go down to 10% (=Rs 1/Rs 10).
Emotional arguments based on an imaginary unequal playing field between American and other global banks are fallacious. It cannot be an American national priority that its banking industry in the walled street is successful internationally, even if it exposes the global economy to unnecessary risks and costs. To forestall the arrival of another costly financial crisis, US legislatures and regulators need to ask Wall Street to have more skin in the game, while banks expectedly lobby against such requirements. The US Treasury and its Secretary, given its much-touted independence, cannot allow flawed arguments and empty jingoism sway economic policy making.