Risky business: Fresh threats in new bank rules

 
Patrick Artus
A NEARLY unanimous consensus (by governments, the International Monetary Fund, the European Commission and the European Banking Authority) is calling for a further increase in the regulatory capital of banks, in particular for those in the Eurozone.
The rationale for this is that if banks have more capital they will more easily weather crises and they will have an incentive to take fewer risks. The second part of this widely propounded argument, however, needs to be questioned.

In reality, economic theory does not allow us to ascertain whether an increase in the regulatory capital of banks reduces or increases bank risk-taking. There are two opposing arguments on this point: argument A, the widely accepted view, places the emphasis on shareholders’ limited liability; argument B, the contrasting argument, focuses on expected returns on equity.

ARGUMENT A: LIMITED LIABILITY
The shareholders of a bank have limited liability: they cannot lose more than the total of the bank’s capital. This leads them to encourage greater risk-taking by the bank, increasing the bank’s debt leverage, and this was indeed the case in the Eurozone until 2008, with some financing of risky projects.

The explanation for this is simple. A risk-free utilisation of the bank’s funds will generate a fixed level of profit. Yet a riskier utilisation of funds, if successful, will generate a greater level of profit. If the bank falters then shareholders will be protected by their limited liability, so it is this protection that will encourage shareholders to support risky investments.

However, if the regulatory capital of the bank is raised then the protecting effect of limited liability is reduced, because shareholders will have more to lose. Therefore an increase in bank capital will lead to shareholders preferring risk-free utilisation of the bank’s funds.

ARGUMENT B: BANKS’ RETURN ON EQUITY
Economic theory can, however, also point to the opposite conclusion.

If banks are required to hold more regulatory capital, then their return on equity decreases, as can already be seen since 2007. If the shareholders of banks have an objective with respect to the expected return on equity then, in order to prevent it from declining due to the rise in regulatory capital, they will be encouraged towards riskier investments and asset purchases. This is because, logically, greater risk-taking will provide a higher expected return on invested capital. Therefore an increase in the amount of capital banks have to hold will lead to an increase in risk-taking behaviour.

In contrast, then, to the existing consensus that sits behind recent and upcoming regulatory changes, it is important not to assume that an increase in the regulatory capital of banks will automatically lead to a reduction in bank risk-taking.

Patrick Artus is global chief economist at Natixis.