Better Capitalised Banks Lend More and Lend Better

"The Royal Stock Exchange, City of London, UK, at night"

By Stephen G. Cecchetti & Kermit L. Schoenholtz

Are higher capital requirements really a drag on economic growth? Many people seem to think so. We disagree. In this essay, we describe how better capitalised banks experience lower funding costs, and how undercapitalised banks have an incentive to “evergreen” loans to low-quality firms. Our conclusion is that higher capital requirements are good for economic growth, resulting in both more lending and better lending.


Many people seem to think that when capital requirements increase, banks lend less. Adherents of this view go on to argue that, since credit is essential for economic growth, we should not impose overly tough constraints on banks. This is the basis for the conclusion that we have gone too far in making the financial system safe and the cost is lower growth and employment.

US Treasury Secretary-designate Steven Mnuchin appears to share the view that financial regulation has restrained the supply of credit: in a recent interview, he is quoted as saying “The number one problem with Dodd-Frank is that it’s way too complicated and cuts back lending.”1 One interpretation of this is that Secretary-designate Mnuchin will support proposals like House Financial Services Chair Jeb Hensarling’s Financial CHOICE Act to allow banks to opt for a simple capital standard as an alternative to strict regulatory scrutiny.2

Our reaction to this is three-fold. First, for most US banks, which are very small and pose little threat to the financial system, a shift toward simpler capital requirements – so long as they are high enough – may be both effective and efficient; for the largest, most systemic intermediaries, higher capital requirements should still be accompanied by strict oversight. Second, we see no evidence that higher bank capital is associated with lower lending. In fact, quite the opposite. Third, given that the 2007-09 financial crisis was the result of too much borrowing, not all reductions in lending are bad. We take each of these points in turn.3

Recently, we wrote about the Minneapolis Plan to End Too Big to Fail and its proposal to sharply increase required equity in the 13 largest US banks.4 Specifically, the Minneapolis Plan calls for a pure leverage ratio – the ratio of common equity to total assets – of at least 15% and possibly as high as 24%. The current requirement is 6%, and the CHOICE Act would require only 10%. Unlike the CHOICE Act, the Minneapolis Plan also embraces important aspects of current regulation (including stress tests and living wills) to contain the systemic risks of the largest, most complex, and most interconnected banks, while simplifying regulatory compliance for small banks that do not pose a threat to the financial system. We believe that the Minneapolis Plan provides a solid basis for legislation that would advance the public goal of making the financial system safe in a cost-effective way.


Important in this conclusion is our judgment that higher capital does not hamper the aggregate supply of credit. The alternative view appears to posit a choice between bank balance sheet consolidation, on the one hand, and credit growth, on the other. In fact, there is no inconsistency between making banks safer and ensuring long-run growth of credit. To see why, recall that from the bank’s perspective, equity capital is one of the sources of funds while loans and securities acquisitions are uses of funds. That is, the former is a liability while the latter are assets. In theory, an increase in bank equity can be used to fund an increase in credit provision.

But that’s theory, what about experience? Here, the evidence is compelling: strong banks lend to healthy borrowers, weak banks don’t. On the quantity of lending, countries with better capitalised banking systems prior to the start of the crisis in 2006, experienced stronger lending growth during and after the crisis.5 That is, higher capital did not slow recovery. Furthermore, research at the BIS has established that better capitalised banks experience lower funding costs, higher growth of debt funding, and higher growth of lending volumes.6

Turning to the quality of loans, scholarly studies examine both Japan and Europe. Caballero, Hoshi and Kashyap describe how, in the 1990s, regulatory forbearance delayed a thorough recapitalisation of Japan’s banks for more than a decade.7 Instead, insolvent Japanese banks made loans to keep insolvent Japanese borrower afloat. In their study of the impact of the ECB’s recent actions, Acharya et al. conclude that extremely accommodative monetary policy had a similar impact.8 That is, undercapitalised euro-area banks had an incentive to evergreen loans to
“low-quality” firms.

These results rely on data from a range of countries. What happens in the United States when bank capitalisation rises and falls? To answer this question at an aggregate level, we have plotted below bank credit (relative to GDP) on the vertical axis and bank capital (relative to assets) on the horizontal axis. The filled-red circle at the top right is the most recent observation from the third quarter of 2016.


Source: Federal Reserve Board, H.8 and Bureau of Economic Analysis, National Income and Product Accounts.

The results are striking: rather than the downward-sloping relationship that critics of higher bank capitalisation anticipate, the relationship is strongly positive. That is, greater reliance of banks on equity funding is associated with an increase of credit!

Finally, there is the fact that decreases in lending are not necessarily bad. In fact, quite the opposite. That is what the studies of Japan and Europe highlight: loans to zombie firms made by weak banks reflect an inefficient allocation of savings and lead to slower economic growth. And surely no one wishes to see a return to the over-indebtedness of US households that contributed to the vulnerability of the financial system in 2007.

We also believe that, given the experience of the financial crisis, it is essential to ensure that borrowers are able to repay, both to protect the financial system and to protect taxpayers.9 The latter concern applies to mortgage borrowing, which is now effectively guaranteed by the US government through the government-sponsored enterprises (GSEs). It also applies to student loans, which (in addition to being guaranteed by the federal government) account for nearly half of consumer credit and create decades-long financial burdens that are virtually impossible to escape even through personal bankruptcy. And then there is payday lending, which, while frequently beneficial, can also be exploited to prey on the least well-off in the United States and has been a focus of both the US Department of Defense and the Consumer Finance Protection Bureau.

So, what has happened to US indebtedness since the financial crisis? BIS data show that aggregate credit to the US private non-financial sector peaked at the height of the crisis (the third quarter of 2008) at 169.3% of GDP; the latest reading (first quarter of 2016) puts it at 150.1%. Virtually all of this drop is accounted for by the decline of credit to households – from 97.1% to 78.4%. And, since only a bit more than one fourth of the decline reflects a fall in bank credit, most of it arises from the behaviour of nonbank intermediaries.

Data from the Federal Reserve Bank of New York highlight this changing mix of intermediation that, in our view, has made the financial system more resilient and less vulnerable since the crisis. The following chart depicts the evolution since 1960 of the liabilities of three important components of the financial system: commercial banks; broker-dealers and bank holding companies (BHCs); and shadow banks (net of their own holdings of other shadow banks’ liabilities). While the commercial banking system has grown since 2007, the other segments have shrunk. Specifically, over this nine-year period, shadow banking has plunged from 120% of GDP to 76% of GDP (that’s from a peak of $18.0 trillion to a current level of $13.4 trillion). A substantial portion of this correction occurred before the July 2010 enactment of the Dodd-Frank Act, reflecting the crisis-driven demise of the underlying business model of wholesale banking without deposit insurance or a lender of last resort.


BHC Bank holding company. Source: Financial Accounts of the United States; Adrian, Tobias, Daniel Covitz, Nellie Liang (2013) Financial Stability Monitoring, Federal Reserve Bank of New York Staff Report 601. Updates courtesy of the FRBNY.


We conclude: (1) higher capital levels are associated with more lending, with better lending, or with both; and (2) to the extent that enhanced regulation hampers lending, it is often of the type that makes the financial system less safe and can leave taxpayers on the hook.
From this evidence, we conclude: (1) higher capital levels are associated with more lending, with better lending, or with both; and (2) to the extent that enhanced regulation hampers lending, it is often of the type that makes the financial system less safe and can leave taxpayers on the hook.

To be clear, we do see great scope for improving and simplifying US financial regulation. Among other things, the system could use massive streamlining; the GSEs still need restructuring; living wills and the resolution mechanism should compel systemic intermediaries to self-insure (in order to avoid bailouts); government guarantees need to be properly priced; and the financial infrastructure could be more resilient.10 But, if we’re to make the financial system both safe and efficient, we need not only much higher capital requirements, but also a strict regulatory regime that makes credible the government’s (and legislators’) promise not to bail the most systemic intermediaries.


About the Author

Stephen G. Cecchetti is Professor of International Economics at the Brandeis International Business School, Research Associate at the NBER, and Research Fellow at the CEPR, former Chief Economist at the Bank for International Settlements, and former Director of Research at the Federal Reserve Bank of New York.

Kermit L. Schoenholtz is Professor of Management Practice in the Department of Economics of New York University’s Leonard N. Stern School of Business, Director of NYU Stern’s Center for Global Economy and Business, a member of the Financial Research Advisory Committee of the U.S. Treasury’s Office of Financial Research, and former Global Chief Economist at Citigroup.

1. Schlesinger, Jacob M., “Trump Treasury Choice Steven Mnuchin Vows to ‘Strip Back’ Dodd-Frank,” Wall Street Journal, 30 November 2016.
2. See
3. See Schularick, Moritz and Alan M. Taylor, “Credit Booms Gone Bust: Monetary Policy, Leverage Cycles and Financial Crises, 1870-2008” American Economic Review, Vol. 102, No. 2, April 2012, pp. 1029-61.
4. See Cecchetti, Stephen G. and Kermit L. Schoenholtz, “Ending Too Big to Fail,”, 28 November 2016 and The Minneapolis Plan to End Too Big to Fail, Federal Reserve Bank of Minneapolis, 16 November 2016.
5. See Cecchetti, Stephen G. and Kermit L. Schoenholtz, “Higher capital requirements didn’t slow the economy,”, 15 December 2014.
6. Cecchetti, Stephen G. and Kermit L. Schoenholtz, “Bank Capital and Monetary Policy,”, 20 June 2016; and Gambacorta, Leonardo and Hyun Song Shin, “Why Bank Capital Matters for Monetary Policy,” BIS Working Paper No. 558, April 2016.
7. See Caballero, Ricardo J., Takeo Hoshi and Anil K Kashyap, “Zombie Lending and Depressed Restructuring in Japan,” American Economic Review, Vol. 98, No. 5, December 2008, pp. 1943-77.
8. See Acharya, Viral A., Tim Eisert, Christian Eufinger, and Christian W. Hirsch, “Whatever It Takes: The Real Effects of Unconventional Monetary Policy,” unpublished manuscript, October 2016.
9. See Cecchetti, Stephen G. and Kermit L. Schoenholtz, “Rolling the dice, again,”, 21 October 2014.
10. For a broader list and discussion of Dodd Frank’s accomplishments and failings see Cecchetti, Stephen G. and Kermit L. Schoenholtz, “Dodd-Frank: Five Years After,”, 15 June 2015.


The views expressed in this article are those of the authors and do not necessarily reflect the views or policies of The World Financial Review.