Bank Capital Proposals Will Starve the Main Street Economy

The banking agencies are pushing through huge and unjustified reductions in big bank capital requirements, but—they argue—lower bank capital would result in more lending and economic growth. The reality is that the proposed capital rules would reward big banks for lending to the wealthy, large corporations, and other financial institutions, causing them to divert critical financial resources away from the Main Street economy. As if that isn’t enough, the proposed rules also would further the steady disappearance of community banks.

Despite whatever propaganda the big banks put out showcasing their support for Main Street, the truth is that big banks serve big clients, and it shows in the data. Last year, lending by big banks to other financial institutions (such as hedge funds and nonbank lenders) grew by nearly 60 percent, whereas their lending to real-economy households and businesses did not grow at all—zero percent. The three biggest banks made almost 80 percent of their mortgages to borrowers with high down payments, as opposed to only around 55 percent for community banks. Also, community banks hold around 40 percent of small business loans even though their share of total bank assets is only 15 percent, showcasing what true support for Main Street looks like.

Put simply, big banks do a lot of lending to the wealthy, large corporations, and other financial institutions, and proportionally not much lending to Main Street as compared to more traditional community banks. In fact, big banks don’t do much lending to the real economy at all, lending out only around 40 percent of their deposits to households and businesses, far less than the 75 percent of deposits lent out by community banks.

The capital proposals would reward the current big bank lending behavior by disproportionately reducing capital requirements for exactly the type of lending big banks already do. Lower capital means higher profits, and big banks do everything they can to maximize their profits, including shifting their financial activities away from those with higher capital requirements and towards those with lower capital requirements. That is, relative capital requirements matter a lot to big banks.

Starting with mortgages, the proposals would change the mortgage capital requirement framework from being a fixed requirement to one that is lower for mortgages with higher down payments and vice versa. Put another way, mortgages made to borrowers who make substantial down payments (generally wealthier borrowers) would be more profitable than those made to those with small down payments (typically low to middle-income borrowers). Better Markets estimates that the aggregate capital requirement on big bank mortgages would decrease by 40 percent because, as noted above, big banks originate proportionally more mortgages to borrowers with higher down payments.

Lending to large corporations by the biggest banks would benefit in the same way. Like mortgages, the proposals would change the corporate loan capital requirement framework from a fixed requirement (100 percent risk weight) to one that is much lower for “investment grade” companies (65 percent risk weight), a 35 percentage point reduction. Shockingly, the largest banks be able to subjectively decide on their own if a company is considered “investment grade.” Large corporations would benefit the most because they have publicly listed securities that trade in financial markets in which investment-grade classifications are provided. Small to mid-sized companies generally do not have this luxury.

Being a subjective decision, however, means public securities aren’t necessary, nor is prior approval from the banking agencies. Of course, the banks would use this to apply the investment-grade classification to as many corporate borrowers as possible, especially their hedge fund, private equity, and other investment fund clients, which are their most lucrative borrowers. Better Markets estimates that roughly half of GSIB corporate loan books could end up classified as investment grade under this process, cutting the corporate loan capital requirement by 17 percent. Additionally, loans to nonbank lenders would receive their own lower capital requirement, driving more lending to nonbank financial institutions, as described in our previous post.

This all adds up to even more big bank lending to the wealthy, large corporations, and other financial institutions, and higher big bank profits. While defenders of the proposal argue that it will lead to better risk management by incentivizing lending to more creditworthy borrowers, the agencies provide no explanation as to why this framework is better than the one that has been in place. In practice, the new framework just ends up meaning lower capital requirements and higher profits for big banks and less lending by big banks to households and small businesses. Additionally, the proposed requirements may actually increase risk by incentivizing more lending to nonbank financial companies, whose interconnections and risks to the mainstream banking system are not well understood. In other words, what is wrong with the framework that’s in place now?

Importantly, there are practical economic implications that cannot be ignored. Incentivizing big banks to do more of the type of lending they already do would further drive the uneven “K-shaped” economy and wealth and income gaps, because they would be diverting critical financial resources away from households and small to midsized businesses. Furthermore, lower capital means a greater chance that big banks will fail and cause devastating economic harm, especially to Main Street.

Not only are there implications within the big banks, but the proposals would also exacerbate the steadily increasing concentration in the banking system, which also hurts the Main Street economy. As noted above, community banks are much more supportive of households and small businesses than big banks because their foundation is a “relationship lending” model that allows them to lend to a more diverse set of borrowers. The proposals would increase the unfair competitive advantage the biggest banks already have over community banks, resulting in big banks taking more and more market share. Over time, this would further starve Main Street of the type of financial support provided by community banks.

The agencies must go back to the drawing board and at least fully justify the changes, considering the practical costs and benefits. They must consider whether their proposed changes draw us further from the purpose of having a taxpayer-supported banking system in the first place, which is that banks are supposed to be foundational to durable, broad-based economic growth for all Americans. Because, as proposed, the banking agencies’ framework would further entrench a system where banks just lend to other financial institutions and the fortunate few instead of ensuring all Americans have access.