So the idea is that with higher capital ratios banks are less prone to ‘get in trouble’.
So let’s say minimum capital requirements go from 8% to 10%. Most banks try to stay about 1% over the limit to be safely compliant.
That means that when requirements were 8%, most banks had 9% to be ‘safe’ and with 10% required, banks are at 11% to be ‘safe’
Now let’s say today’s banks have losses of 2% of capital, which brings them down to 9%, 1% under the new limit. When that happens is the regulators call it a ‘troubled bank’ and suspend new lending until ‘good standing’ is restored. And cessation of bank lending triggers a general, downward, pro cyclical credit contraction.
In other words, the increase in capital requirements didn’t prevent the same 2% drop in capital from having the same negative effect.
Yes, the increased capital may help to protect ‘tax payer money’ to some degree should banks be liquidated, but it does nothing to protect the macro economy from a contractionary pro cyclical downward spiral.
And all it takes is a drop in asset prices to shut down lending, a risk I pointed out late last year when oil prices collapsed. Stocks were the cheapest source of borrowing for many, and with that equity evaporating that lending contracts. Lending vs commodities related collateral also contracts. etc.
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