The cost of capital

Last week, President Obama called on banks to increase lending. Banks don’t need that call — the president’s regulators do. That’s because tighter lending is the unintentional but direct result of the Dodd-Frank Act and the Obama administration’s own priorities.

The narrative used by the administration — that credit seized up during the financial crisis and has been tight ever since — just isn’t true. When the recession officially ended in the middle of 2009, consumer credit at the largest 100 banks shot up, increasing from $880 billion to $1.2 trillion. One year later, the Dodd-Frank Act — which was designed to make the financial service system safer and stronger — was passed. Consumer credit at big banks has contracted ever since.

Some blame borrower pessimism about the economy, but there is strong reason to believe that Obama administration regulators are the driving factor.

Regulators are requiring banks to hold unprecedented amounts of capital — arguably over and above what is needed to protect the industry from another meltdown. To pass the Federal Reserve’s recent stress tests mandated by the Dodd-Frank Act, banks had to stay solvent against conditions worse than the last recession and maintain a significant capital buffer to boot. Banks were forbidden from paying out dividends unless they passed the test, and they must hold this vast amount of capital regardless of present or projected economic stress.

Fortifying banks to this extent is not free. Capital on banks’ books is like money under a mattress. It cannot be used for profit-oriented activity, like loans. Because banks can leverage loans, an old industry rule of thumb is that each additional dollar of capital restricts lending by $7 to $10.

That rule of thumb suggests the impact of tight regulations on lending is massive. Over the past five years, banks have increased Tier 1 capital — the core measure of safety from a regulator’s point of view — by nearly 30%, from $991 billion to $1.26 trillion, the highest in history. This increase in capital alone represents nearly $2 trillion in forgone loans or, presuming an average mortgage size of $200,000, about 10 million home mortgages.

To top it off, when banks do lend, regulators apply “capital punishment” through a process called risk weighting. Regulators assign risk weights to bank assets based on their perceived riskiness. The higher the risk weight, the more capital the bank has to hold against that asset. The joint notice of proposed rulemaking from the Federal Deposit Insurance Corporation, Federal Reserve, and Office of the Comptroller of the Currency on Basel III is a perfect example. Home mortgages are given a risk weight of up to 200%, meaning that banks must hold a lot of additional capital if they want to be in the mortgage lending business. Meanwhile, sovereign debt for E.U. countries is given a 0% “risk weight.” Yes, this includes Cyprus.