Do Market Failures Justify Bank Capital Adequacy Regulation?

One of the most important elements of contemporary financial regulation is bank capital adequacy regulation — the regulation of banks’ minimum capital requirements.  Capital adequacy regulation has been around since at the least the 19th century, but whereas its previous incarnations were relatively simple, and usually not very burdensome, modern capital adequacy regulation is vastly both more complicated and more heavy-handed.

After I first began research on this subject years ago, I watched the Basel Committee take part in a remarkable instance of mission creep: starting from its original remit to coordinate national banking policies, it expanded into an enormous and still growing international regulatory empire.  Yet I also noticed that no-one in the field seemed to ask why we needed any of this Basel regulation in the first place.  What, exactly, were the market failure arguments justifying Basel’s interventions generally, and it’s capital adequacy regulation in particular?

On those occasions when regulatory authorities make any attempt to justify capital regulations, they typically settle for mere assertion.  The following little gem from a recent Bank of England Discussion Paper on the implementation of Basel in the UK is typical:

Capital regulation is necessary because of various market failures which can lead firms on their own to choose amounts of capital which are too low from society’s point of view.[1]

The authors don’t bother to say what the market failures consist of, let alone prove that they actually are present.  Nor do they even hint at the possibility that banks may choose unduly low levels of capital, not because of market failure, but because they are encouraged to do so by government deposit insurance or central banks’ offers of last-resort support.  Instead, there is a mere appeal to that ethereal entity, “society,” the incontrovertible opinion of which is that financial institutions ought to hold more capital than they would be inclined to hold if left to their own devices.  Policymakers are, furthermore, privy to this opinion, though why they should be so is also left unexplained.

On those rare occasions when genuine market-failure arguments for capital adequacy regulation are put forward, they are less than compelling.  An example was recently provided by my friend, the former Bank of England economist David Miles.  In an appendix to his thoughtful valedictory speech as a member of the Monetary Policy Committee last summer, David sketches out a simple model to “illustrate the tendency for unregulated outcomes to create too much risky bank lending.”

In his model, banks operate under limited liability, which allows them to pass on high losses to their creditors.  They also take risky lending decisions, but depositors do not see the riskiness of the loans that their bank makes.  Miles then obtains an equilibrium in which banks with lower capital are more prone to excessively risky lending, and he suggests that the solution to this problem (of excessively risky bank lending) is to increase capital requirements.

Let’s grant the point that banks with low capital levels would be prone to excessively risky lending. Let’s also agree that the solution is higher capital.  Miles would have this solution implemented by regulators increasing minimum capital requirements.

However, the same solution could also be implemented by depositors themselves.  They could choose not to make deposits in banks with low capital levels.  In a repeated-game version of the model, they could also run on their bank if their bank’s capital levels fell below a certain threshold.  Weakly capitalized banks would then disappear and so, too, would the excessively risky bank lending.

The mistake here — and it is a common one among advocates of government intervention — is to come up with a solution to some problem, but then assume that only the government or one of its agencies can implement that solution.  To make a convincing case for state intervention, they have to explain why only the government or its agencies can implement that solution: they have to demonstrate a market failure.[2]

A more substantial argument for capital adequacy regulation, also by David Miles, was published in the European Economic Review in 1995.  (See also here.)  The essence of this argument is that if depositors can assess a bank’s capital strength, a bank will maintain a relatively strong capital position because greater capital induces depositors to accept lower interest rates on their deposits.  However, if depositors cannot assess a bank’s capital strength, then a bank can no longer induce depositors to accept lower interest rates in return for higher capital, and the bank’s privately optimal capital ratio is lower than the socially optimal capital ratio.[3]  Information asymmetry therefore leads to a bank capital adequacy problem.  Miles’s solution is for a regulator to assess the level of capital the bank would have maintained in the absence of the information asymmetry, and then require it to maintain this level of capital.

There is, however, a problem at the heart of this analysis.  Consider first that the technology to assess and convey the quality of bank assets either exists or it does not.  If the technology does exist, then the private sector can use it, and there is no particular reason to prefer that the government use it instead.  There is then no market failure.  On the other hand, if the technology does not exist, then no-one can use it, not even the government.  Either way, there is no market failure that the government can feasibly correct.  To assume that the technology exists, but that only the government can use it, is not to demonstrate the presence of a market failure, but to assume it.

Of course, we all know that the technology in question does exist, albeit in imperfect form.  The traditional solution to this asymmetric information problem is for the shareholders (or, more accurately, bank managers acting on behalf of shareholders) to provide externally audited reports.  These reports are made credible by the managers and the auditors being liable to civil penalties in the event that either party signs off on statements that are materially misleading.  If they issue misleading statements, aggrieved creditors could then pursue them through the courts.

A potential objection is that this solution requires a high level of financial competence among depositors that cannot be expected of them.  In fact, it does not.  Instead, all it requires is that there are analysts who can interpret audited reports, and that they, in turn, convey their opinions to the public in a form that the public can understand.  The average depositor does not have to have a qualification in chartered accountancy; instead, they only need to be able to read the occasional newspaper or internet piece about the financial health of their bank and then make up their minds about whether their bank looks safe or not.  If their bank looks safe, they should keep their money there; if their bank does not, they’d better run.

One should also compare the claims underlying any model and the predictions generated by it against the available empirical evidence.  In this case, the claim that depositors cannot assess individual banks’ balance sheets is empirically falsified, at least under historical circumstances where the absence of deposit insurance or other forms of bailout gave depositors an incentive to be careful where they put their deposits.  To quote George Kaufman on this subject:

There is … evidence that depositors and noteholders in the United States cared about the financial condition of their banks and carefully scrutinized bank balance sheets [in the period before federal deposit insurance was introduced].  Arthur Rolnick and his colleagues at the Federal Reserve Bank of Minneapolis have shown that this clearly happened before the Civil War.  Thomas Huertas and his colleagues at Citicorp have demonstrated the importance of [individual] bank capital to depositors by noting that Citibank in its earlier days prospered in periods of general financial distress by maintaining higher than average capital ratios and providing depositors with a relatively safe haven.[4]

The Miles position is also refuted by the empirical evidence on the bank-run contagion issue.  If Miles is right and depositors cannot distinguish between strong and weak banks, then a run on one bank should lead to runs on the others as well.  Yet the evidence overwhelmingly indicates that bank runs do not spread in the way that the Miles hypothesis predicts.  Instead, there occurs a “flight to quality,” with depositors withdrawing funds from weak institutions for redeposit in stronger ones.  The “flight to quality” phenomenon demonstrates the very point that Miles denies, i.e., that depositors have been able to tell the difference between strong and weak banks.

So, once again, there is no market failure.

I should add, in concluding, that I’ve addressed these two arguments by David Miles because they are the best market-failure arguments for capital adequacy regulation that I’m aware of.  I invite readers to point me to stronger arguments if they can find any.


[1] Bank of England, “The Financial Policy Committee’s review of the leverage ratio,” October 2014, p. 12.

[2] There are also two other “first-best” solutions in Miles’ model that do not involve government or central bank capital regulation.  The first is where a bank has a 100 percent capital ratio, in which case the risk of loss to depositors would be zero, but only because there would no longer be any depositors.  The “bank” would no longer be a bank either, because it would no longer issue any money: instead, it would become an investment fund.  The second is to eliminate limited liability to prevent bank shareholders walking away from their losses.  In this context, one should recall that limited liability is not a creature of the market, but a product of the limited liability legislative interventions in the 19th century.

[3] The fact that there is a suboptimal equilibrium in which banks maintain lower-than-optimal capital levels is also a little odd, and would appear to reflect the informational assumptions that Miles made in his model.  If depositors are not sure of the quality of their bank’s assets, we might have expected them to insist that their banks maintain higher rather than lower capital levels, or else keep their money under the mattress instead.  I thank George Selgin for this point.

[4] Kaufman, G. G. (1987) “The Truth about Bank Runs.” Federal Reserve Bank of Chicago. Staff Memorandum 87–3, pp. 15-16.

[Cross-posted from]