First, we should be clear on what capital really is. Despite phrases such as “capital cushion” or “holding capital”, capital holdings are not the same as reserves. Capital is meant to describe a type of funding structure, not an asset allocation -- a liability, not an asset. So what is truly at stake here with the capital requirements debate is how banks fund themselves: through equity or debt.
The argument for higher equity funding comes down to reducing the incentive to run on the banks. Because debt liabilities are fixed, creditors are likely to demand their money back at the first sign of trouble. On the other hand, if the funding comes from equity, there is no similar compulsion to run, thereby preventing the fire sale spirals that characterise financial distress.
To visualize this, consider the following bank balance sheet. On the left we have the funding sources -- debt and equity -- and on the right we have the assets. In this first diagram, we see a bank that relies heavily on debt funding (95%) and has very little equity (5%) -- a situation characteristic of many banks today.
Figure 1: Highly Leveraged Bank
If the bank’s assets lose value and drop by a small amount, say 7%, because the debt quantities must stay constant, then all of the equity is wiped out and the bank is left insolvent. On the other hand, had the bank financed itself through mostly equity, then the bank would have stayed solvent and not all the equity would have been wiped out. There would have been less of an incentive to have a run on the debt and, in a time of financial stress, the bank would have avoided a fire sale. These examples illustrate why high levels of debt financing can be so problematic in a system of hard to calculate risks.
Figure 2: Insolvent Bank
Equity funding prevents sudden runs and insolvency. That is the key justification for stricter capital requirements. With this in mind, I now turn my attention to the relationship between these new financial regulations and monetary policy.
The most important relationship between capital requirements and monetary policy is that capital requirements make the financial stability and “reaching for yield” arguments against monetary easing so much weaker. If institutions are well capitalized, what are we scared of? Equity bubbles, like the 2000’s dot com bust, do not leave lasting damage. However, debt bubbles, such as the 2008 financial crisis, can trigger an extended period of deleveraging and general economic malaise. Much as Scott Sumner has recommended, capital requirements can help keep the finance out of macro. While I personally believe insights from the financial literature may reveal more light on the mechanisms of monetary policy, I do agree that the task of monetary policy should stay very separate from that of financial regulation. Monetary policy makers can direct the guidance of interest rates towards maintaining a stable level of nominal output, whereas financial regulators focus on making sure the banks do not fall apart. If institutions are reaching for yield, leave it for regulators to cut the arms off. The monetary authorities need not pay any attention to it.
Even if these capital requirements are not implemented, the mere prospect of them greatly weakens the case for using monetary policy for financial stability purposes by exposing a contradiction: if monetary policy is surgical enough for financial markets, why aren’t capital requirements?
In Jeremy Stein’s February speech on monetary policy and financial stability, he argued that it may be appropriate for monetary policy to prevent bubbles. One of his key justifications was that monetary policy can “[get] in all of the cracks” of financial markets to stamp out bubbles. However, this neglects the bluntness of monetary policy.
In my view, to the extent that interest rates get in all the cracks, they do so by reducing the financial edifice into rubble. But if I am wrong and if monetary policy is indeed precise enough to stamp out bubbles without collateral damage, then aren't capital requirements even more surgical? Indeed, while monetary policy can affect the entire economy’s consumption and investment behavior, the Mogdiliani-Miller theorem suggests that changes in the capital structure would barely have an effect on those macroeconomic aggregates. The greatest irony is that the financial types who support tighter monetary policy to control financial risks are often the same ones who are against stricter capital requirements. But these views are inconsistent. Capital requirements are tailored for financial regulation, and to the extent one supports the blunt use of monetary policy, one should support the strengthening of capital requirements even more.
On the other hand, while capital requirements may make the task of monetary policy easier, some have argued that the reduction in credit from the stronger capital requirements goes against the goal of expansionary monetary policy. First, I do not believe this is true on a purely finance theory basis. As has been discussed elsewhere, higher capital requirements are unlikely to increase funding costs. To the extent that they do raise funding costs, this reflects an efficient reduction in the government’s implicit subsidies for bank debt. Second, even if this were the case, we should remember that monetary policy is not credit policy. If there is a reduction in credit, the question for the monetary authorities is whether this reduces nominal GDP. Depending on that, the Fed should ease or tighten. Therefore, a well functioning monetary policy should fully offset the potential impact of credit shocks. The level of credit in an economy is a matter of financial organization, something far outside the domain of monetary policy. The Fed should adjust the path of interest rates depending on where they want to see nominal GDP go.
While the above discussions focus on how capital requirements make monetary policy easier, I also believe better monetary policy, especially through a nominal GDP target, can help make capital requirements simpler. It’s useful to remember that debt is an extremely important channel through which nominal shocks have real effects. Rarely are these bonds written with inflation indexing, so stabilizing nominal aggregates can help make satisfying capital requirements easier. Under a nominal GDP target, the size of the debt chunk of the balance sheet can stay roughly around the same level as the size of the equity chunk, reducing the amount of scrambling that can occur in financial markets as bank struggle to reach their regulatory goals.
To conclude, I should note that there is an elegance in the combination of nominal GDP targeting, a robust monetary policy regime, and high capital requirements, a robust financial regulatory regime. As Plosser recently noted:
In the context of monetary policy, I have long advocated simple, robust rules and transparent communications.2 Robust rules are important because they are intended to work well in a variety of environments. This reflects our limited knowledge about the true determinants of economic outcomes. Economists have also come to understand that using policies that are optimal in one specific economic model can often deliver very poor outcomes if that model proves incorrect. So a policy rule that operates well under a wide range of models is a better and more robust approach.
The same approach applies to the design of regulatory frameworks as well. Because the financial world is very complex, there is merit in simple, transparent regulatory solutions designed to work reasonably well in a wide range of situations. We want rules that regulators can enforce without having superhuman knowledge or foresight. However, we can predict with virtual certainty that private actors will seek to evade regulatory restrictions and taxes. This is often called "regulatory arbitrage." We also know that enforcement costs rise as firms' incentives to evade regulations increase.
In my view, simple mechanisms that are harder to evade — and even better, mechanisms that utilize market forces to discipline firm behavior — are superior to an elaborate list of rules that seeks to cover every possible outcome. Simple and transparent regulatory mechanisms make it easier for market participants to predict how regulators are likely to behave. This, in turn, makes it easier for regulators to credibly commit to implementing the regulations in a consistent manner.
Reading Plosser’s second and third paragraphs really shines light on some common issues such as commitment, credibility, and transparency that relate financial and monetary policy. For monetary policy, these qualities can help guide the expectations that give monetary policy its oomph. For financial regulation, these qualities limit the hidden fault lines that can make crises so severe. One can only hope that policy can combine these all these qualities to make a more enlightened monetary and regulatory framework.