Bigger cushions against losses make banking safer

The notion that some enormous banks could be “too big to fail” is one of the most disturbing and unavoidable facts of modern global finance.

It’s disturbing because it is grossly unfair, puts taxpayer funds at risk and gives big banks an advantage over small ones. It is unavoidable because no sane government would allow an institution with trillions in assets and liabilities to implode and wreak havoc on global markets.

What to do? A number of Wall Street critics have long demanded that large financial institutions be broken up, a cause eagerly championed these days by Sen. Bernie Sanders of Vermont, who is seeking the Democratic presidential nomination. After briefly considering that approach in 2009, Congress opted simply to force banks to limit their risks.

It wasn’t an ideal solution, but it has worked surprisingly well, and the government has resisted industry pressure to go soft.

That became evident last week when the Federal Reserve finalized rules that require the very largest banks to maintain significant capital buffers to protect them in a financial crisis.

In the 2008 crisis, some of the worst offenders on Wall Street had capital reserve ratios of 30 to 1, or even higher. That is to say, only about 3% of what they were lending out was their own money. The rest they had borrowed.

An international agreement approved in 2010 requires all institutions to maintain at least 7% capital. The Fed’s new rule adds a “surcharge” on top of that ranging from 1% to 4.5%. The surcharge would be a function of how big the bank is and how much it uses short-term loans to fund long-term investments, a practice that got multiple Wall Street firms in trouble in 2008 and is, sadly, picking up again.

The Fed’s approach is constructive. The stricter capital rules will give banks bigger rainyday funds during times of volatility. Pegging them to overnight lending will discourage banks from engaging in risky behavior. And, as a total package, the tougher standards might even persuade some banks to break up.

The banking industry often complains that tough capital standards will serve as a damper on the economy as banks lend less. This is undeniably true. But it’s a bit like saying you shouldn’t water the lawn because it will make the grass wet.

The very purpose of tougher capital standards is to decrease risk. And less risk means less potential for reward. But if the crisis of 2008 taught anything, it is that financial institutions were taking on far too much risk — at the public’s expense.

U.S. banks also complain that if they have to comply with tougher capital standards than banks in other countries, they will be put at a competitive disadvantage. Being a safer institution, one better able to survive a crisis, is its own competitive advantage.

“Too big to fail” is not going away. But the Fed’s tough capital standards make failure less likely.