Banking is a fundamental piece of our global economy, and soundness of banking is a desired goal for all governments. Since banks provide essential services, the collateral harm of their default and failure has large consequences, as we have witnessed over the history of banking and particularly in the last decade. The purpose of this document is to discuss risks that still affect financial institutions, and to make policy recommendations related to Chilean Banks General Law; in particular, a call for increased capitalization.
One of the easiest and most direct ways of insuring a firm’s solvency is through a strong capitalization ratio or so-called leverage ratio, measured as Equity over Assets (E/A). A highly capitalized firm has higher ability to absorb losses without defaulting on its debt, while a less capitalized and more heavily indebted firm is more prone to default and has higher probability of facing bankruptcy. If a firm has low capitalization, its owners benefit fully from the upside of the investments, while they share losses with creditors. This may create moral hazard and can lead to excessive risk taking in investments and excessive use of debt.
Firms in most industries rarely have less than 35% equity relative to total assets. However, the ratio for banks is typically less than 10%, although until the first part of the 20th century, their equity was routinely above 20% of assets. Deposit insurance and implicit bailout guarantees enable banks to borrow more easily and often more cheaply than they would have been able to do absent the guarantees. The guarantees often provide an implicit subsidy to the banks.
The Basel Accords were first signed in the 1980s as an international attempt to restore banking soundness. One of its purposes was to set minimum capital requirements for banks, but the requirements were set at very low levels. Banks also have found creative ways to comply with Basel regulation without increasing their true indebtedness.
One of the main reasons behind the subprime mortgage crisis of 2007-9 was the low capitalization levels of mortgage corporations, insurance companies and banks. Poorly capitalized financial institutions were unable to cope with broad house-price drops and massive mortgage failures in 2007. Fortunately, in this case, Chilean banks were not affected by the global subprime financial crisis, because of their low integration with international banking and low exposure to complex securities.
However, Chile’s current international reputation for sound banking and historic responsible macroeconomic administration are in danger in the event of any future financial crisis, which remains a risk. The Chilean Congress is discussing a new Banking Law that will fully adopt the Basel III accords and will update the Chilean regulation to align with international standards. Current Chilean law establishes a minimum leverage ratio at 3%, and the new Banking Law under consideration will not alter significantly this requirement. We believe that this current attention on banking reform brings an opportunity to improve substantially the regulation by introducing an additional capital requirement.
Our proposal is to include a simple leverage ratio of 9%, which is equivalent to the average capitalization of Chilean banks. For non-complying banks, we propose restrictions on paying dividends to stockholders until the limit is achieved. This capital requirement will not affect banks’ business, since it does not impose any restriction to lending or to other banking activities.
Setting a higher equity requirement means a guarantying that banks’ solvency will not fall below current levels. This step would improve the ability of banks to face potential future losses, benefiting the economy and taxpayers. It would place Chile at the international vanguard of banking regulation.