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July 15, 2013

Markets Call Bull on Banks’ Warnings About Capital

“Would a safer financial system be bad for the economy? Big banks say it would, because tougher banking rules will squeeze their lending and hold back investment. Markets don’t seem to agree.

The relationship between banking and economic dynamism will be a crucial topic in coming weeks, as U.S. regulators collect comments on new capital rules aimed at making the country’s largest banks more resilient. A proposal published earlier this week would require bank holding companies to fund each $100 in assets with at least $5 in capital — equity from shareholders and other forms of financing that, as opposed to borrowed money, can absorb losses and prevent insolvency in times of crisis. Some officials have suggested going farther and setting the requirement at $10, and we’ve said we agree. The global minimum is $3, a level at which a net loss equal to only 3 percent of assets would be enough to render a bank insolvent.

Banks warn that a higher capital requirement could be disastrous. They say they will have a hard time raising the necessary equity from investors on desirable terms. Instead, they will reduce the capital ratio’s denominator — assets — to meet the requirements, or charge more for loans. The result will be less credit for companies looking to expand and for people looking to buy houses; the slow recovery might stall altogether.

If financial markets thought this prediction was likely, they would react negatively to announcements of higher capital requirements. Stock prices should fall on concerns that companies would face a credit crunch. Bond prices should rise on expectations that the Federal Reserve would be forced to keep interest rates low to support the recovery.”

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Read full Bloomberg editorial here

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