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McDonald: Financial Institutions Safer, but at What Cost?

A bank with 100 percent capital is not a bank. It is a pile of money. The purpose of a bank is not only to act as a safe place to store your money, it is also to lend money out to help businesses invest, to help individuals achieve their dreams and to grow our economy.

The constant clamor for higher capital levels in Washington, D.C., misses entirely the second goal of banks in our economy. Whenever we increase capital levels in banks, we make banks safer but lessen their ability to support the growth of our economy.

Higher capital levels may be the right choice for making the system safer, but they are not always the right choice for the economy. At some point, higher capital levels give up more in growth than they gain in safety.

All of this begs the question, what is the current level of capital at banks compared with historical norms? One new way to gauge the safety and soundness of the financial sector is the Hamilton Financial Index. The HFI combines two measures to provide a snapshot of the financial sector’s ability to handle risks in the system.

The first metric is the Tier 1 Common Capital Ratio, which shows the amount of capital banks have relative to the riskiness of the assets on their books. The Tier 1 Common Capital Ratio for the industry has increased 34 percent since the fourth quarter of 2008 and now stands at an all-time high of 12.76 percent.

The second metric is the St. Louis Financial Stress Index, which measures systemic risk through 18 economic variables. The St. Louis Financial Stress Index has reduced significantly since the crisis.

This combination of higher capital levels and less systemic risk has increased the HFI from 0.46 during the crisis to 1.22 as of the first quarter of 2012.

Compared with the historical norm, the HFI is currently 22 percent above average and is just slightly off the all-time high of 1.24 set in the second quarter of 2011.

Though events in Europe are a threat to American financial institutions, U.S. banks have continued to reduce exposure to the European periphery. Recent data from the Federal Financial Institutions Examination Council shows that U.S. banks have actively reduced exposure to Greece, Spain, Italy, Ireland and Portugal by 16 percent from the first quarter of 2011 to the first quarter of 2012. Moreover, U.S. banks have decreased their exposure to Europe as a whole by 8 percent during that same time period.

Risks still exist, however, and in the second quarter of this year fears surrounding the Greek election drove systemic risk significantly above its first-quarter levels.

Yet for the HFI to dip below historical norms, systemic risk would have to increase five times the second-quarter high. Conversely, if banks had not increased their Tier 1 Common Capital Ratio from the level of three years ago, the second-quarter high of systemic risk would have pushed the HFI below normal levels. The increase in capital levels during the past three years has better positioned U.S. financial institutions to manage market risks.

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