Raising Capital Standards in the US is Going to Be a Long and Drawn Out Fight

It is easy to dismiss the G20 communique and all the associated spin as empty waffle. Ask people in a month what was accomplished in Pittsburgh and you’ll get the same blank stare that follows when you now ask: What was achieved at the G8 summit in Italy this year?

Perhaps just having emerging markets at the table will bring the world closer to stability and more inclined towards inclusive growth, but that seems unlikely. Should we just move on – back to our respective domestic policy struggles?

That’s tempting, but consider for a moment the key way in which the G20 summit has worsened our predicament.

There is broad agreement that capital requirements need to be increased and a growing consensus that very large banks in particular should be required to hold bigger equity cushions. This is a pressing national priority – if our financial system is to become safer – and reasonable people are starting to put numbers on the table, ever so quietly: Joe Nocera is hearing 8%, but Lehman had 11.6% tier one capital on the day before it failed and the US banking system used to carry much more capital – back in the days when it really was bailout free (think 20-30% in modern equivalent terms (see slide 40 here).

Obviously, raising capital standards in the US is going to be a long and drawn out fight. The G20 could help, if it set high international expectations, but the opposite is more likely. As Nocera suggests this morning, the inclination of the Europeans – largely because of their funky “hybrid” capital, but also because they have some very weak banks – will be to drag their feet.

Why should we care? This administration seems to think that we need to bring others with us, if we are to strengthen capital requirements. Our progress will be slowed by this thinking, the glacial nature of international economic diplomacy, and the self-interest of the Europeans.

Instead, the US should use its power as the leading potential place for productive investments to make this point: If you want to play in the US market, you need a lot of capital. If you would rather move your reckless high risk activities overseas, that is fine.

It’s time to get past the thinking that our economic prosperity is tied to the “competitiveness” of the financial sector, when that means doing whatever finance wants and keeping capital standards low.

As we discovered over the past 12 months, undercapitalized finance is not a good thing – it is profoundly dangerous and expensive. Other countries should be encouraged to raise capital standards also, but if they can’t or won’t, then their financial institutions will (a) not be allowed to operate in the United States, and (b) be allowed to interact in any way with a US bank only to the degree that the US entity carries an extra (big) cushion of capital in those transactions. Any US entity found circumventing these rules will be punished and its executives subject to criminal penalties.

Of course, this process needs to be WTO-compliant and the G20 is as good a place as any to manage the high politics of that. But stop worrying about what other countries might or might not do. Establish high capital requirements in the US, and make this a beacon for safe and productive finance.

And prepare for the crises that will sweep undercapitalized parts of the world financial system in the years to come.