When trillions of dollars in loans and other assets went bad in the financial crisis, banks across the globe were unprepared to absorb the losses. The bank failures and government assistance that followed led policymakers in the U.S. and worldwide to tighten regulations for financial institutions. At the center of these new regulations are higher capital requirements. The idea is that a well-capitalized bank will be able to handle major writedowns of its assets without defaulting on its creditors and depositors.1 By inducing banks to internalize their losses in this way, regulators seek to prevent banks from straining federal deposit insurance funds and especially to prevent government bailouts.

Their overarching objective, however, is to foster a more stable financial system. The nature of commercial banking is inherently unstable, as banks fund their long-term lending mostly with short-term debt in the form of insured deposits or by borrowing from other banks or from investors by issuing bank bonds. This high degree of leverage in the financial industry means that, if confidence in the financial system is shaken, as happened in 2008, even banks that are not exposed to catastrophic losses are vulnerable to panic selling of assets to meet worried depositors’ and creditors’ sudden demand for liquidity. Requiring banks to hold a larger portion of their liabilities in the form of equity is intended to reduce the risk that they will be forced to sell off their assets at fire-sale prices and trigger the sort of contagion that threatened the global financial system in 2008.2

Not only the financial sector but also the whole economy benefits from confidence in the banking system, since financial turmoil often precedes deep recessions. Such crises are very costly. During the Great Recession, U.S. GDP dropped more than 5 percent from its previous peak, 8.8 million jobs were lost, and the federal government spent $250 billion to stabilize banks and $82 billion to stabilize the U.S. auto industry.

This article appeared in the Second Quarter 2018 edition of Economic Insights. Download and read the full issue.

[1]With enough capital, a bank may be able to handle major losses by cutting dividends, liquidating a fraction of its safe assets, and injecting new capital.

[2]In economic jargon, capital regulation is intended to reduce the moral hazard of risk-taking by financial institutions that operate under limited liability and deposit insurance. Moreover, bank capital acts like a buffer that may offset losses and save banks’ charter value.

[3]Another reason that it is not always straightforward to measure the cost of a crisis (or the benefit of higher capital requirements) is that crises occur very infrequently in developed economies. Therefore, many studies use information on financial crises in developing economies, which are generally accompanied by currency crises or sovereign debt crises, which complicates comparisons. For historical databases on credit booms and crises, see, among many others, the studies by Moritz Schularick and Alan Taylor; Enrique Mendoza and Marcos Terrones; or Helios Herrera, Guillermo Ordoñez, and Christoph Trebesch.