Ending bank bailouts and capital requirement regulations

New research by the Institute of Economic Affairs has shown that capital regulations are much less necessary than what we may think. Economists Forrest Capie and Geoffrey Wood have analyzed British banking in the 19thcentury, and they have concluded that lack of capital requirements did not translate into chaos or anarchy. Rather, financial firms adjusted their capital ratios according to to the degree of risk that they were undertaking.

In fact, this study shows that capital provisions during these years were much more robust than those mandated under today’s Basel agreements. Prudent management used to be the norm, mainly because the “too big to fail” doctrine was not popular among governments or central banks.

Nowadays, we find the opposite scenario. Public authorities are now willing to bail out financial institutions that are deemed systemic, and such implicit guarantee gives banks a significant incentive to push their risks to the limit. What is the impact of this morally hazardous consensus? A study published by the IMF recently estimated that the value of this “subsidy” is equivalent to $83 billion dollars per year. Such figure means that large U.S. institutions would barely make any profits without this special privilege.

How can this be possible, you may ask yourself? Well, the larger banks grow, the more likely they will be considered “too big to fail”. Hence, banks can borrow at lower rates and thus engage in risky behavior that would otherwise be off the table.

The following infographic, produced by Bloomberg, puts the IMF study in perspective… and the picture is certainly not a pretty one.

Should the “too big to fail” doctrine be abandoned, capital requirements would also be superficial. Since banks would have to survive without bailouts, their survival would depend on properly assessing how high their levels of capital should be.

Diego Sánchez de la Cruz is an analyst at Libertad Digital. His work on international economics has been published in different media outlets.

Written by Diego Sánchez de la Cruz, IE Master in International Relations Alumnus