Testing the case for bottom-heavy banks
BANKS used to be harder to topple than they are now. As the chart in this week’s Free exchange print article—Strength in numbers—shows they used to hold much more equity, a financial shock absorber that sits at the bottom their balance sheets. When banks were bottom-heavy, they were safer. But shock-absorbing equity comes with costs too. This is why some banks and commentators are worried about new plans to raise equity ratios. The concern is that with higher ratios loans to households and firms would be in short supply or too costly. Are new regulations going to put the world into a sustained credit crunch?
On a long view the evidence suggests not. To see why, start with the demands of the new rules. Basel 3 requires a 7% common equity ratio. Because the assets in this ratio are risk-weighted, it must be converted into a simple (un-weighted) ratio to make it historically comparable. A simple ratio of about 3.5% is about right. (Average risk weights were often around 50% in the old Basel system, they will rise a bit with Basel 3, but tend to fall over time.)...
Apologies to May and the ghost of Mercury.
Brian May CBE; songwriter; astrophysicist (PhD Imperial College London); Chancellor, Liverpool John Moores University; sometimes musician, Queen.