The global economy is facing its biggest set of challenges since the financial crisis 15 years ago. Historically high inflation is driving up interest rates around the world, a global economic slowdown is afoot, deglobalization is reversing decades of growth in trade and geopolitical tensions are flaring.
But there is a key difference between today’s economy and the dark days of 2008. This time around, the U.S. banking system is healthy — and well positioned to be part of the solution as opposed to the source of the problem.
Now, as regulators weigh whether to impose stricter requirements on banks, they risk choking off one of the economy’s biggest sources of strength — at a time when that strength can do the most good for the rest of the economy.
Today, unlike 2008, banks are already very well capitalized and can handle more uncertainty than ever before. Banks’ increased loss-absorbing capacity since the Great Recession is just one example. Countless painful but necessary regulatory requirements have been implemented over the past decade and a half to ensure the system is ready for the next big stressor.
As a result, at end of the second quarter of 2022, the eight so-called globally systemically important banks based in the U.S. had $1.1 trillion in total capital reserves (versus just $678 million at the end of 2008) and an average Tier 1 capital ratio of 13.6% (versus 10.2% in 2008). This long and arduous effort to rebuild bank capital is a significant accomplishment in itself.
What’s more, most observers expect banks’ earnings to continue growing — not least owing to rising interest rates, which would cushion banks from consumer credit losses. Earnings are the first line of defense against unexpected losses and enable banks to further pad their capital cushions. The eight biggest U.S. banks posted $92.6 billion in net income in the first three quarters of 2022, 12% greater than the average in the same period from 2017 to 2020.
A third cushion banks enjoy is the ability to reduce or eliminate stock buybacks and dividends. A bank can keep its earnings to invest in growth or shore up its capital reserves, or it can pay them out in the form of dividends and share buybacks. In 2021, the total capital distributions for this same group of banks totaled $121 billion, of which nearly $89 billion was share buybacks. Turning off buyback programs is often the least disruptive way to husband capital.
When you add it all up, banks are almost certainly capable of absorbing even the most severe projected stress events.
That’s why, given the tough economic circumstances expected in the months ahead, regulators should tread carefully. Most important, they should refrain from further raising capital requirements for the banking system, which would crimp the provision of credit, liquidity and other bank intermediation that is so vital for the economy.
One way to think about the financial system is as a trampoline that absorbs downward shocks and helps the rebound of declining economic indicators through lending and other services. Banks can be effective counterweights to the negative economic, financial and geopolitical factors that we may experience in the future. But raising capital requirements now, as some policymakers are proposing, would be “procyclical” rather than countercyclical; instead of absorbing shocks, it would magnify them.
A more restrictive regulatory stance would also take away the opportunity to put the newly armored banking system to the test. Bank leaders and regulators need to be able to learn from the system’s reaction to real-life adverse conditions and observe its ability to handle risks and stresses so they can adjust the dials in the future based on real, lived experience.
All signs point to the coming year being a challenging period for the U.S. and global economies. Regulators ought to use the robust capital and liquidity built up by banks to help the overall economy weather challenges and return to sustainable growth. And they should allow banks the space to invest in preparing for emerging operational risks for which they may not be as well prepared as the traditional financial risks they have been protecting against for so long.
Some may remember the tense 1993 exchange between then-U.S. Ambassador to the U.N. Madeleine Albright and then-Chairman of the Joint Chiefs of Staff Colin Powell during a debate on whether the U.S. should step in to stop the fighting among ethnic groups in Bosnia. Albright famously exclaimed, “What’s the point of having this superb military you’re always talking about if we can’t use it?” Politics aside, banks are the U.S. economy’s “superb military.” Regulators would be wise to use that immense power, so painstakingly developed since the global financial crisis, to bail the rest of us out.