Report: Financial institutions need a lot more capital

Three economists from the Bank of England have concluded financial institutions need much more capital than they’ve had in the recent past or than Basel III proposes.

David Miles, Jing Yang and Gilberto Marcheggiano say banks need to raise more money by selling stock and less by taking on debt.

“A capital ratio which is at least twice as large as that agreed upon in Basel would take the banking sector much closer to an optimal position,” they state in their January 2011 report

Many experts believe the best way to prevent another financial crisis is to make banks have a lot more capital, which is bank jargon for equity. This money could act as a buffer in a crisis, and banks that couldn’t get it would be forced to downsize.  

Other observers, however, believe banks can always game their capital requirements, as they did in recent years by getting inflated ratings and moving business of their books, and anyway no amount of capital can stop an irrational run on the financial markets.

From the trio’s paper:

In retrospect we believe a huge mistake was made in letting banks come to have much less equity funding – certainly relative to un-weighted assets – than was normal in earlier times. This was because regulators and governments bought completely the view that “equity capital is scarce and very expensive” – which in some ways is a proposition remarkable in its incoherence (as shown with clarity and precision by Admati, De Marzo, Hellwig and Pfleiderer (2010) and with wit and humour by Merton Miller (1995)).

We believe the results reported here show that there is a need to break out of the way of thinking that leads to the “equity is scarce and expensive” conclusion. That would help us get to a situation where it will be normal to have banks finance a much higher proportion of their lending with equity than had been assumed in recent decades to be acceptable. And that change would be a return to a position that served our economic
development rather well, rather than a leap into the unknown.