How much capital should a bank have?

The great Yogi Berra said, “If you don’t know where you’re going, you will end up someplace else.” The policy measures identified with Dodd Frank, more capital, the Volcker rule, capital adequacy tests, and living wills illustrate a fundamental misunderstanding of the cause of the 2008 financial crisis. The United States, Britain, Iceland, Ireland, and Spain had banking crises at about the same time. Greece and Portugal had sovereign debt crises. The common cause of these crises was that the variability in their capital account surpluses was too large. In the three or four or more years before the crisis in each of these countries, the economy had to adjust to a sharp increase in the capital account surplus, which led to a surge in asset prices or a surge in government indebtedness. Then the capital account surpluses declined and the economy of each of these countries then had to adjust to this decline.

The prices of stocks and real estate in these countries declined, which often led to large loan losses. The banks had a solvency problem, which was always associated with a liquidity problem. Bagehot’s sage advice had been that the central bank should provide unlimited amounts of liquidity at a penalty interest rate. He also suggested that the government should not provide assistance to insolvent institutions. The U.S. government wanted Lehman to remain open, but it would not commit public sector funds to enhance Lehman’s capital. The decision to allow Lehman to fail was the mostly costly mistake in U.S. financial history, because it led to a massive decline in spending.

The paper presents a proposal that unlimited capital should be provided to banks during crisis as a way to prevent the consolidation of banks. The wealth of the current shareholders would be diluted, new managers would be installed, and the board of directors banished to Siberia.