Bank capital requirements contribute to growth and stability

Recent proposals from House Republicans and the Department of Treasury intend to scale back the bank capital requirements and regulatory burdens created under the Dodd-Frank Act. Those making the recommendations argue that capital requirements constrain credit to businesses and households, and that cutting them would boost lending, growth, and jobs. Some proposed actions, like simplifying the capital requirements on community banks, have merit. Others—making mandatory stress tests less frequent, reducing capital requirements for the large and complex banks, and eliminating the Orderly Liquidation Authority—would increase the risks of macroeconomic instability.

In a keynote address (PDF) to the International Finance and Banking Society last week, Brookings Senior Fellow Nellie Liang discussed the role of bank capital regulations in promoting financial and economic stability. Liang’s speech outlines a growing body of research that should be central in debates surrounding capital regulations, credit, and growth. Higher capital offers net benefits by reducing both the probability of financial crisis and the severity of such crises.  While borrowing may be more expensive relative to risk-free rates now than it was just prior to the financial crisis, there is little to no evidence that the current financial regulatory regime has constricted credit in the U.S. Banks have substantially increased their capital ratios since 2009. Yet loan growth at commercial banks (excluding residential mortgages) has been strong in recent years, and broader measures of credit for businesses and households have also risen.

Capital policies designed to offset the pro-cyclicality of credit and of static capital regulations themselves can also provide net benefits to macroeconomic stability. The countercyclical buffer (CCyB), for example, would build capital at banks when credit is expanding rapidly and would be released safely when the cycle turns, to preserve banks’ capacities to lend during recessions which would avoid making recessions worse.  In the U.S., annual stress tests provide some offset to the pro-cyclicality of financial conditions, but would be enhanced through the implementation of a CCyB.