Conclusion
The Basel III reforms requiring stronger capitalization of banks have not gone far enough: The additional gains from reducing crisis risk would outweigh the additional costs of more capital.
The equity capital target for large banks needs to be set about a third higher than in Basel III to reach the point at which marginal costs equal marginal benefits. Tangible common equity needs to reach 7 to 8 percent of total assets (12 to 14 percent of risk-weighted assets) rather than the Basel III target of 9.5 percent of risk- weighted assets for the largest banks. A level of 13 percent of risk-weighted assets also seems to be emerging as a central estimate among a number of studies adopting alternative approaches (see table 2.1).At the same time, the shortfall from optimal capitalization is far smaller than some critics have argued. Moreover, in practice the large US banks appear to be holding capital relatively close to the optimal level, reflecting a behavioral cushion. It would seem more prudent, however, to set the target as a requirement than to count on this voluntary behavior.
A natural question is why the TLAC target of18 percent of risk-weighted assets would not effectively meet or even exceed the optimal capitalization level. The problem with this approach is that CoCos and subordinated debt raise the risk of panic dynamics and (in the case of subordinated debt) contagion associated with the bankruptcy implications of imposing debt haircuts. The principal role of the extra TLAC remains one of assuring taxpayers rather than ensuring systemic stability. By implication policymakers would do well to increase the equity component of the TLAC requirement, providing a larger buffer against potential bankruptcy while leaving some role for the disciplinary influence of nonequity TLAC.