After reading about Obama’s proposals for limiting the size of banks, it has occurred to that there may be a more nuanced way to prevent banks becoming ‘too big to fail’, without having to put an explicit cap on their size or market share. Banks currently have to keep a certain percentage of their deposits in the form of safe capital (effectively cash or government bonds), and the percentage of deposits that banks are required to hold in low-risk assets like these are known as capital requirements. It’s generally accepted that higher capital requirements mean that banks are more stable, but conversely when banks have to put more of their deposits in safe capital, there’s less to fund lending elsewhere. Over the past few decades capital requirements have gradually shrunk, increasing the ability of banks to lend, but making them more susceptible to financial shocks, like the one we’ve experienced over the past couple of years. Unsurprisingly, many are now calling for capital requirements to be increased considerably, to try to prevent future crises.
Which leads me to my question for those with more knowledge of financial regulation than I do; why not make capital requirements non-linear with regard to the size of the bank? Or, in more simple terms, why not force bigger banks to keep a higher percentage of their deposits in safe assets than smaller banks do? The reasoning for this is fairly straightforward; small banks can have a relatively high failure rate without posing systemic risk to the wider financial sector, whereas the fall of a single large bank can be catastrophic for the entire economy (hence the phrase ‘too big to fail’). The structure of capital requirements could be rejigged such that small banks would have modest capital requirements, and as bank size increases, so do their capital requirements. This could be continued to the extent that once a bank became ‘too big to fail’, its capital requirements would be almost 100% (making it in effect a narrow bank), meaning it would become, in theory at least, ‘too stable to fail’.
Unlike an across-the-board increase in capital requirements, such a system of non-linear capital requirements would give smaller institutions the capacity to continue with a healthy level of lending, while still ensuring that the largest banks are sufficiently stable. Furthermore, it would have the advantage of not requiring an explicit cap on the size of banks (which in fact already exists in the US, but has been repeatedly breached over the past couple of decades). Instead, the market itself would settle the appropriate sizes for banks, balancing between the needs of stability and lending capacity.
While most of you reading this will already know how much of a policy nerd I am, if you needed any further proof it would be my reason for supporting Barack Obama in the 2008 US Presidential election against John McCain. While I wasn’t decisively swayed one way or another by the broad policy positions on foreign affairs, economics, etc., I decided to take a closer look at the specifics of their environmental policies (which were very similar on the surface). They both proposed a cap-and-trade system of reducing emissions, but Obama promised that 100% of the emissions credits would be auctioned off, whereas McCain had in mind a system where some of the credits would be auctioned, and others allocated by Congress. As similar as they were on the surface, Obama was proposing a cap-and-trade system that works, and McCain was proposing one that doesn’t, so I shifted my support to Obama.
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