Background: As per the Fed's CCAR, banks have been required to maintain a minimum total capital adequacy of 8%of which a minimum of 5%is common equity capital of their risk weighted assets. Taking lessons from the Global Financial Crisis of 2008-09and the subsequent bailing out of banks by their national governments, we have designed this paper to point out a serious flaw in the Fed's Capital Adequacy Requirement(CAR).
Data/Methods: To prove our point, we have linked our paper with the CCAR Loss Model, which aims to measure risk and forecast expected losses on bank's loans under different economic scenarios. Non-payment of loan balances by consumers when they get unemployed causes losses to lender banks. To prove our point we took data from January2007 to December2014 on credit card default by borrowers and consequent losses as an asset class for banks and linked it with the macroeconomic time series data on GDP,unemployment, inflation and other variables.
Results/Expected Results: Under a stressed scenario the future prospect of a bank's profitability falls, hence the market value of banks' common equity falls. On the other hand the riskiness of bank loans increases because borrowers are likely to default more when they don't have jobs. Under such an adverse economic scenario the investors also don't invest in banks and run to safe havens like the US treasuries which evaporates liquidity from the capital market. Thus instead of stabilizing the banks, the rigid percentage of capital adequacy requirement during adverse economic scenarios will destabilize the banks. Preventive measures under CCAR are thus worse than the disease.
Policy Implications: The Fed should take a long-term view of the survival of banks and relax the rigidity of the minimum common equity capital adequacy of 5%and total capital adequacy of 8%during recessions.