Do higher minimum capital requirements for banks do any good? July 21, 2011 at 5:24 pm
Here’s the problem.
If we set a minimum capital requirement, it is just that, a minimum. Banks have to meet it. The capital that they use to meet that requirement is trapped: it can’t absorb losses, as if it does, the bank is below the minimum, and that is not allowed.
The market also plays a role here. If a certain level of capital is required, then the market will demand that banks have at least that much before they will allow them to roll their debt. So again this capital is not available to absorb losses.
There is an argument then that raising minimum capital levels does not improve the ability of banks to absorb losses at all. All it does is decrease the loss to the taxpayer after banks fail. (In this argument banks fail for liquidity reasons while still close to being well capitalized due to the market declined to roll their debt.)
Rather, what makes banks more likely to be able to continue as going concerns is a relatively low level of required minimum capital, with banks holding higher levels of actual capital above that. The excess over the minimum is actually available to absorb losses.
Food for thought, perhaps, as Basel III implementation begins in Europe.