How to improve bank capital requirements

Here’s a proposal for how bank capital requirements could
be restructured.

1. The bank’s capital must equal a certain percentage
   of deposits (perhaps 8 percent).

2. The capital would be calculated by the current market
   capitalization of the firm (stock price times number of shares).
   The important idea here is that both market capitalization
   and deposits are objective values available contemporaneously.

3. Banks must issue contingent convertible bonds (CoCos) whose
   market value equals or exceeds the capital requirement value.

4. Instead of reserve requirements, banks face the
   basic requirement that they must always redeem their deposits
   (checking accounts on demand; time deposits on schedule).

5. A bank needing funds to redeem deposits can automatically
   borrow from the Federal Reserve discount window (if it needs
   to — it can first turn to the Federal Funds market to borrow
   from other banks).

6. If a bank’s capital share falls too low it must
   buy back shares in order to raise its share price (more
   about this in a later post). It can borrow from the Federal Reserve if it needs to in order to do this.

7. If the banks total debt to the Federal Reserve exceeds
   8 percent of deposits, then the technical failure of the
   bank is immediately triggered. This means the bank
   equity shares become worthless, and the contingent convertible
   bonds are converted into equity. The current bank management
   is replaced. The bank operates under regulatory control
   in a kind of receivership until it is able to sell enough
   new contingent convertible bonds that it can resume independent
   operation. Or, it is sold off to another bank. The decision
   would be made by the new owners (the former CoCo holders)
   subject to the approval of the regulators.

Under this proposal banks have greater freedom to
conduct their day-to-day operations without
excessive regulation, but there is an automatic
procedure for when the current bank managers lose
control of their business to the regulators. There
would be less uncertainty about how and when this
would happen, and the capital requirements will
not pressure banks to hold seemingly-safe-but-really-risky
assets like mortgage backed securities. Also,
this proposal makes clear that the paramount duty
of a bank is to always be able to redeem its deposits.

recommended reading:
“How to Bring Market Discipline Back to Banking”,By Stephen Matteo Miller, Jul 23, 2015 (Mercatus Center, George Mason University)
…
previous posts in this series:

• part 1 of bank capital series
• part 2 of bank capital series
• Note about movie “The Big Short”

……………..
–Douglas Downing
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