By Elinda F. Kiss
Although the stock market has already fallen 9 percent in the new year (primarily as a reaction to concerns about China and cheaper oil), we are not headed for another financial crisis that could lead to full-blown economic meltdown, as in 2008.
Why? For one thing, households hold less debt than they did seven years ago, and banks hold more common equity capital — 12.5 percent of risk-weighted assets today vs. 5.5 percent seven years ago. What's more, the Federal Reserve conducts regular stress tests of U.S. banks, to see if they have sufficient capital to withstand significant blows to the economy and financial system (e.g., severe recessions, steep declines in housing prices, steep decline in stock prices), and to ensure they have a sufficient plan to restore capital. The new rules have bite: If a bank fails a stress test, it cannot increase its dividend or repurchase shares; hence, the banks have sufficient incentive to maintain large amounts of equity and good plans.
Additional restrictions have been placed on systematically important financial institutions (or SIFIs) under the Dodd-Frank act of 2010 and the international Basel III plan (which will be fully functional in January 2019 but parts of which are being implemented now). Under Dodd-Frank, SIFIs must prepare a "living will" to show how they can be dismantled without disrupting the financial system (in other words, to prevent the financial crisis that occurred after Lehman was declared bankrupt on September 15, 2008).
Under the requirements of Basel III, banks are holding more common equity capital than they did previously. The bank regulators announced in November 2015, that the 30 largest banks in the world (including 8 in the U.S.) will be required to hold more "TLAC" (Total Loss Absorbing Capacity) in the form of both equity capital and long term debt. The rules state that each bank must issue a minimum level of long-term debt. By 2019, the eight largest banks in the US will hold a combined $120 billion in new long-term debt that can absorb bank losses before the depositors (or the Deposit Insurance Fund or U.S. taxpayers) suffer any losses. If a bank got in trouble and the losses used up all of the capital provided by its shareholders, the debt investors’ money would essentially be used to recapitalize a new, healthy bank. So, there would be no need for the government to provide funds for an equity infusion nor even to lend to the bank.
The Fed is seeking a minimum total loss-absorbing capacity — a combination of shareholder equity and debt — of at least 18 percent of risk-weighted assets for the eight American institutions designated as global systemically important banks.
Since the large institutions are less likely to fail and since some of them (e.g., Citi and G.E.) are making themselves smaller, we are less likely to have a financial crisis that leads to an economic crisis; certainly not from the 9 percent decline in stock prices this year. I still believe in stocks for the long run. Since the Great Depression, equities have outperformed other financial assets.
Elinda F. Kiss is an associate clinical professor in the Smith School's department of finance.
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