Capital, also known as equity, is the money that banks get from shareholders and retained earnings. Unlike debt, it has the advantage of absorbing losses, a feature that makes individual banks and the whole system more resilient. Bank executives typically prefer to use less equity and more debt -- that is, more leverage -- because this magnifies returns in good times. Hence, capital levels can serve as an indicator of the balance of power between bankers and regulators concerned about financial stability.
Here's a chart showing tangible common equity, as a percentage of tangible assets, at the six largest U.S. banks from December 2001 to June 2017:
The downward slope in the first several years demonstrates the extent to which leverage got out of hand before the crisis. As late as 2008, when the financial sector was already in distress, the Federal Reserve was still allowing banks to pay out capital in the form of dividends, even though some had equity of less than 3 percent of assets. That proved to be a fatal miscalculation: By 2009, forecasts of total losses on loans and securities reached 10 percent of assets. A crippled banking system tanked the economy and had to be rescued at taxpayer expense.
After the crisis, regulators pushed banks to get stronger. The biggest U.S. institutions more than doubled their tangible common equity ratios -- to an average of about 8 percent of assets (or, by international accounting standards, closer to 6 percent of assets). That's an achievement, and better than in Europe, but the starting point was so low that they still fall short of what’s needed. Researchers at the Minneapolis Fed, for example, estimate that capital would have to more than double again to bring the risk of bailouts down to an acceptable level.
QuickTake Capital Requirements
Yet the political will to push for more equity is waning, as the plateau at the end of the chart indicates. After its latest round of stress tests in June, the Fed allowed banks to reward shareholders with billions of dollars in dividends and stock buybacks. Treasury Secretary Steven Mnuchin, apparently with President Donald Trump's backing, has made it clear he'd like to ease capital requirements. The cycle is turning.
This is unfortunate, because adequate equity would do more than just strengthen the financial system. It would give banks the wherewithal to take risks in all environments -- a feature that research has shown to be good for economic growth. Together with some other changes, it could obviate the need for all kinds of burdensome regulations.
In short, whatever lessons we might have learned from the last crisis, they are fading along with memories of how close the world came to financial Armageddon. As a result, we're still far from prepared for the next one -- and we're likely to become less so.
James Greiff at email@example.com