Before 2007, the owners of America’s largest banks contributed as little as three cents of common equity for every dollar on their balance sheets. The capital requirements in place at the time were little constraint on the use of debt by these banks to fund purchases. Given the devastating effect of the financial crisis on US jobs and wealth that followed, would anyone really want to argue that requiring the biggest banks to hold more equity in 2007 would have adversely affected economic growth?
So, last month, US bank supervisors proposed a new capital standard that would limit the largest banks’ ability to finance themselves with excessive amounts of debt. For every dollar of assets and some proportion of off-balance-sheet commitments, the largest banks would hold at least six cents of equity, and their parent holding companies would hold five cents. This cap on the banks’ leverage ratio would significantly increase capital requirements for these banks, enhancing their ability to withstand financial shock and continue lending.
The largest banks are raising objections designed to scare the public and force a retreat from good public policy. The new requirements are not onerous, however. The proposed higher leverage ratio is intended only to reduce the banks’ vulnerability by requiring more owner equity, just as the market would have required of the megabanks if there were no government backstop. Since the early 20th century, capital levels for the largest financial groups have systematically declined from levels exceeding 15 per cent of assets to below 3 per cent for several of the largest banks in 2007.