Have we done enough to regulate finance?

The International Monetary Fund’s annual meetings will be held on October 10-12 in Washington DC, and the world’s financial sector is a central item on the agenda. That will make for an interesting meeting, because two diametrically opposed views of the global financial system will face off against each other.

The first view is that “we have done a lot” since the global financial crisis erupted in 2008. According to this view, which is put forward on a regular basis by some US Treasury officials and their European counterparts, there may be a bit more to do in terms of implementing reforms, but our banks and other financial firms have already become much safer. The crisis of 2008 cannot soon be repeated.

The second view is that we are a long way from completing the far-reaching changes that we need. Even worse, on at least one key point, the very language used among policymakers and leading journalists to describe finance is badly broken.

The issues are complex and nuances abound, but much of what divides the two sides in this debate comes down to this: Is it acceptable to say that banks “hold” capital?

This is an expression used with great regularity among top finance reporters (though not, for example, by Bloomberg/BusinessWeek, which has long been much more careful on this point). “Banks will need to hold more capital” is a common refrain, describing efforts by regulators – and, in the United States, some legislators – to require that financial institutions fund themselves with relatively more equity and less debt.

Using “hold” in this way is both completely conventional and deeply misleading. In any other common English language usage, “hold” is an active verb or a noun with a similar connotation. You hold a baby in your arms. Please hold on tight to this rope. He had a strong hold over his colleagues.

This matters, because “holding” capital has become a disguised or implicit metaphor. The implication is that banks are being asked to sequester part of the asset side of their balance sheets – and this naturally leads to the perception that somehow “less is available” to lend, for example, to the real (non-financial) economy. I encounter this view frequently, even in sophisticated circles – for example, on Capitol Hill.

But this interpretation is a complete – and sometimes deliberate – misunderstanding of bank capital and the policies being pursued. (Anat Admati and Martin Hellwig have pointed out that there are many misperceptions in this area; but, of these, misconstruing capital is surely the most fundamental.)

Capital, in this context, is simply a synonym for equity, which is on the liability side of a bank’s (or anyone’s) balance sheet. It refers to how a bank (or other firm) finances its activities, not to how it uses the funds that it has available.

Higher capital requirements mean, in essence, more equity funding and – by implication, under any sensible definition – relatively less debt for a given balance-sheet size. This is an attractive and sensible policy, because today’s global banks have relatively small slivers of equity underpinning their operations.

The best comparable measures of bank capital are those found in the Global Capital Index produced by Thomas Hoenig, Vice Chairman of the Federal Deposit Insurance Corporation. Hoenig looks at how much equity banks have in the simplest and most transparent measure (also known as leverage). Six years after the world’s largest financial crisis, our megabanks have equity amounting to no more than 5% of their balance sheets. (In fact, some banks have not much more than 3% equity.) That means that 95% of their operations are financed by debt – and thus that only a small negative shock would be needed to push them toward insolvency.

Many measures are still needed to address this vulnerability, including the formalization of international cooperation to handle failing financial firms. We need these firms to be able to fail without causing a global panic. They should prepare meaningful “living wills,” to show how this will be possible; in fact, such plans are a requirement – still unimplemented – of the 2010 Dodd-Frank financial reforms in the US.

But there is a much simpler step that would make a big difference: A senior policymaker, such as a member of the Federal Reserve’s Board of Governors or the president of the New York Fed, should make a speech that explains clearly what bank capital is (and what it is not).

Journalists who ignore the guidance on terminology in this speech should be called – in private – by the Fed. The Fed devotes considerable effort to ensuring that the public understands its monetary policy; officials should devote similar effort to communicating regulatory policy precisely.

And Hoenig’s index should be picked up and publicized by a major organization, such as the IMF. We need not only more precise use of language, but also timely and accurate measurement of banks’ capital levels.

Published in collaboration with Project Syndicate.

Author: Simon Johnson, a former chief economist of the IMF, is a professor at MIT Sloan, a senior fellow at the Peterson Institute for International Economics, and co-founder of a leading economics blog, The Baseline Scenario.

Image: A sign for Bank Street and high rise offices are pictured in the financial district Canary Wharf in London October 21, 2010. REUTERS/Luke MacGregor.