How much capital do banks need to absorb losses?

The appropriate level of bank capital and, more generally, a bank’s capacity to absorb losses, has been a contentious subject of discussion since the financial crisis. Larger buffers give bankers “skin in the game” helping to prevent excessive risk taking and absorb losses during crises. But, some argue, they might increase the cost of financial intermediation and slow economic growth.

In a recent paper, we look at past banking crises and find that had banks had sufficient buffers to absorb losses in the range of 15 to 23 percent of risk-weighted assets, most of these crises would have been avoided (at least for advanced economies). This finding is broadly consistent with recent recommendations on total loss absorption capacity by the Financial Stability Board.

We also review evidence on the costs of holding larger loss absorption buffers and higher capital in particular. We find that most estimates suggest that while these costs tend to be limited in the long run (once banks have adapted to a new regulatory regime), they can be much larger during the transition to higher standards. Any new regulatory minima should therefore be imposed gradually, when conditions allow, and over a relatively long period of time.

Bank loss absorption during crises

In our study, we take two approaches. In the first, we focus on bank losses in past banking crises and ask how much of a buffer it would have taken to absorb them fully through equity (that is without imposing haircuts on bank bondholders or depositors). We look at available data on non-performing loans (NPLs) and the impact of bank losses on capital.

We find that for advanced economies, the level of risk weighted capital that would have enabled banks to absorb losses in 85 percent of crises ranges from 15 to 23 percent. The marginal benefits of additional capital decline sharply past that level (at least from a loss absorption point of view).

In the second approach, we consider how much bank capital would have been needed to avoid public recapitalizations during the 2007-2013 crises.

The results of this exercise are broadly consistent with those based on NPLs. We find that the marginal benefit of additional capital in terms of avoiding public recapitalization episodes is relatively high until risk-weighted capital ratios in the 15 to 17 percent range (which help avoid public recapitalizations in 75 percent of banking crises). But it drops once that level is reached.

A similar bank-level analysis using data on European and U.S banks suggests that a capital of 15 percent in 2007 would have avoided the need for capital injection in almost 55 percent of cases in the U.S. and 75 percent of cases in Europe (based on a sample of available data), while a capital of 23 percent would have eliminated the need for injection in virtually all cases.

The costs of capital buffers

Our study also reviews the growing literature on the costs of bank capital. When thinking about these costs, it is important to distinguish those incurred during the transition to higher levels of capital (transition costs) from the long-term costs (or steady-state costs) associated with a heavier reliance on equity going forward.

The literature finds that long-term costs are small but that transition costs might be significantly higher. In particular, evidence suggests that, during the transition, bank credit grows at a noticeably slower pace. These costs can however be reduced by giving banks ample time to adjust their capital ratios. Therefore, the pace of the transition is an important policy lever.

Other considerations

Our study carries some caveats, however. In particular, from a regulatory standpoint, appropriate capital requirements may be below our suggested range, as banks tend to hold capital in excess of regulatory minima and other bail-in instruments can contribute to loss-absorption capacity. In addition, our approach does not take into account that more capital would likely make banks more prudent in lending (bank owners/managers would have “skin in the game”).

We also suggest above the need for new regulatory minima to be imposed over a relatively long period of time. In particular, timing can be critical since experience shows that markets may pressure banks to anticipate full compliance with new standards, irrespective of regulatory timelines. Also, supervisors should encourage banks to increase loss absorption by raising equity (through new issuance or retained earnings) rather than shrinking assets, so as to avoid reduced credit availability.

Finally, it is important to keep in mind that there is more to capital than loss absorption and there is also more to crisis prevention than improved capital buffers. Our paper focuses on bank capital and loss absorption capacity, but a host of regulatory steps can enhance financial stability including the choice of the regulatory perimeter to address the risks stemming from the shadow banking sector. Further, we have not considered institutional factors that can create room for significant variations across jurisdictions.

By Jihad Dagher, Giovanni Dell’Ariccia, Luc Laeven, Lev Ratnovski, and Hui Tong