Bank capital structures could be bolstered by implementing a novel two-part capital requirement that harnesses equity and uninsured debt, a new Federal Reserve Bank of New York study shows.
The study, “Robust Capital Regulation,” proposes using both core capital requirements (similar to existing rules) and a special capital account to address a bank’s incentive to take on excessive leverage and risk. This two-part system is designed to exploit the role of equity in reducing the risk appetite of banks by requiring them to have more equity in their capital structure, and the role of uninsured debt by making it more desirable for creditors to monitor bank management.
The new capital account would consist of Treasury securities, or their equivalents, that would accrue to the bank’s shareholders as long as the bank remained solvent. If that bank were to fail, however, the lot would be given to regulators instead of creditors. This process would allow regulators to use the securities to support the financial system if it was threatened by failing institutions. Creditors, meanwhile, could have a financial motivation to keep a closer eye on the banks. “In this way, the capital account acts as a deductible on explicit and implicit government insurance claims (prepaid by shareholders) and serves to reduce system-wide losses given default, though not necessarily so for creditors of any bank,” the authors write.
Those authors—New York Fed economist Hamid Mehran, Viral Acharya of New York University, Til Schuermann of Oliver, Wyman & Company, and Anjan Thakor of Washington University in St. Louis—examine the forces that shape banks’ capital structure choices and conclude that their two-part capital requirement structure could accomplish several goals. For one, it could bring more capital into banking and thus contribute to the safety and soundness of the financial sector, without necessarily requiring banks to issue new equity. It could also increase bank incentives to reduce the probability of a crisis and creditors’ incentives to impose discipline on banks. Finally, well-known instruments, such as equity and retained earnings, could be tapped to build up equity—rather than new instruments, whose pricing characteristics and market impact may be hard to gauge.
The study can be read in full in the new Current Issues in Economics and Finance.
Robust Capital Regulation »