Question

Question 1

Should bank capital requirements vary over the business cycle? Give reasons for your answer.

and what are the pros and cons for stakeholders (ie. bank shareholders, depositors, and the wider economy) of higher capital requirements?

Answer 1

President Obama strongly urged Congress to send him solid banking reform legislation soon. Most experts agree reform should include higher capital requirements. “Capital” is one of the most important concepts in banking. Unfortunately, it can be difficult for those outside the financial field to grasp, since there is no close analogy to capital in ordinary life. This primer is therefore intended to provide non-experts with a clear explanation of the basic facts about bank capital and a brief review of the related policy issues which are being debated as part of current proposals to reform the regulation of financial institutions. If bank balance sheets were always accurate and banks always made profits, there would be no need for capital. Unfortunately, we do not live in that utopia, so a cushion of capital is necessary. Banks attempt to hold the minimum level of capital that supplies adequate protection, since capital is expensive, but all parties recognize the need for such a cushion even when they debate the right amount or form.

The Basel Committee on Banking Supervision (BCBS) released, in 2004, the new Basel Capital Accord (usually referred to as Basel II) to address some of the major shortcomings of the previous Basel Accord of 1988 (Basel I), thus fostering stability in the financial system. One of the central changes proposed by Basel II is the increased sensitivity of a bank's capital requirement to the risk of its assets: the amount of capital that a bank has to hold is to be directly connected to the riskiness of its underlying assets. This aspect of the new regulation has raised some concerns, at both academic and policy‐making levels, because it may accentuate the procyclical tendencies of banking, in the presence of an imperfect market for bank capital: if, during a recession, bank borrowers are downgraded by the credit risk models in use, minimum bank capital requirements will increase. To the extent that it is difficult or costly for banks to raise external capital in bad times, this co‐movement in bank capital requirements and the business cycle may induce banks to further reduce lending during recessions, thereby amplifying the initial downturn.