Capital Accounts: Bank Capital, Crises, and the Determinants of an Optimal Regulatory Approach

Abstract

As the financial crisis of 2007-2008 recedes in our rear view mirror, how worried should we be about what lies beyond the bend? According to two highly influential but conflicting accounts of the crisis, we should be very worried. This review essay critiques these accounts, with special focus on the compelling but contradictory narratives they provide of the importance of bank “capital” – the portion of a bank’s activities funded by “unborrowed” money (or equity) – to financial stability. In The Bankers’ New Clothes, Anat Admati and Martin Hellwig launch a withering attack on persistently high levels of bank debt and on the arguments used to defend these debt levels. Misunderstanding Financial Crises, by Gary Gorton, argues that capital levels are unimportant to crisis prevention, focusing instead on financial institutions’ lingering vulnerability to the modern-day equivalent of Depression-era bank runs. Gorton does not, in the end, provide a reason to think capital levels should be required to rise far above zero, while Admati and Hellwig fail to explain why we should not simply prohibit lending institutions from borrowing at all.

The essay evaluates the books’ accounts and argues that while it is vitally important to require banks to maintain a (sufficient) capital buffer, there are also good reasons to limit the size of the required buffer. I identify the factors that should inform the required level of capital, and argue that an optimal regulatory approach would incorporate the best elements of both books’ analyses – weighing the importance of capital against countervailing economic objectives and possible alternative approaches to systemic stability.

Keywords: Financial Regulation, Banking Law, Bank Capital, Financial Crisis