Government regulates banks. These regulations include capital regulation. In theory, capital regulation aims to stabilize the banking system, by ensuring that banks are adequately capitalized. In practice, capital regulation can actually destabilize the banking system, and lead to the replacement of private capital with public capital.
Here’s a brief introduction to the role of capital in banks, the regulation of the capital, and the “stress tests” that regulators conduct while implementing capital regulation.
Banks, like other companies, have assets, liabilities, and capital. Assets are, simply, things you “have.” Liabilities are things you “owe.” The things you have minus the things you owe leaves you with what is left over – capital, or the equity in the enterprise.
Let’s look a little more closely at a simple asset, as a way to start disrobing these simple definitions. The asset at the top of almost all balance sheets is something we call “cash.” There are two basic types of cash, however – cash on hand, and cash in a bank. These are both things that an entity “has,” but they are two very different things, especially in times of crisis. That helps explain why “assets” can be more accurately described as “probable future economic benefits,” and liabilities as “probable future sacrifices of economic benefits.” From there, we begin to see the potential for disruption in counting things, for assets in general, given that different people can have different opinions about how probable or valuable a probable future benefit is. But we have accounting standards that make this attempt, and guide financial statement preparation.
Let’s go to another simple world, a simple bank. This bank has assets, liabilities, and capital. Let’s assume that it has $100 in loans (assets, for a bank), $95 in deposits (liabilities, for a bank, stuff it owes to its depositors), leaving a remainder of $5 in capital. Let’s assume the loans become less probable to be paid back, and decline in value by 10%. Poof – the capital is gone! Ninety minus ninety five equals negative five. And capital isn’t the only thing that is gone, given that capital can’t go negative, in a world with corporations and limited liability. The deposits have been injured, as well.
This is basically why, other things equal, more capital tends to lead to more stable banking. Had this bank been 20% capitalized, as opposed to 5%, the 10% decline in asset value would still have left some equity lying around, and depositors would be less likely to run on the bank.
So, the story goes, government steps in and regulates these things, in order to make sure banks are adequately capitalized. Especially since government insures deposits.
Unfortunately, it doesn’t always work so well.
In our latest and greatest financial crisis, our banking system proved to be sorely undercapitalized and brittle, despite, or more likely, because the Federal Reserve and other banking regulators were regulating their capital. Longer story short, the risk facing the public purse arises if banks suspect the public purse is there for them on the downside, and think they don’t need as much private capital to inspire depositor confidence. And if the regulators are captured by the banks, the risk to the public purse can be amplified.
So, what are these ‘stress tests’ they talk about? Stress tests are very complicated, but they are basically hypothetical accounting exercises like what we just did above. Regulators consider various scenarios and consider what could happen to bank asset values, and how much stress they could pose for banking capital.
How stressful are these stress tests? In Kevin Dowd’s view, not very. See this, and this.
What should we do about this, if anything? Ed Kane developed some very interesting ideas. He believes that bank accounting should explicitly recognize taxpayer equity in “too big to fail” (TBTF) institutions that are threatening the public purse, and corporate fiduciary law should develop a fiduciary duty for managers of TBTF institutions to taxpayers as well as shareholders.