This article was first published in Financial Times.
The writer, president and chief executive of the Federal Reserve Bank of Minneapolis, oversaw the Troubled Asset Relief Program in 2008-09
In the early stages of the pandemic, I called for large U.S. banks to raise $200 billion of equity capital as a preventive measure to ensure they would have the financial wherewithal to endure a severe COVID-induced downturn.
Small businesses across America, which had been forced to lay off staff, were telling their landlords they would not pay rent until the crisis had passed. Those landlords were, in turn, telling their banks they would not be making mortgage payments.
At that point of the COVID crisis, we did not know how the accumulated costs would affect the banking sector. Much would turn on how the virus progressed and mutated and how health care systems responded.
Banks did not heed my advice. More than a year later, what actually happened? The COVID crisis was worse than I feared, with 600,000 deaths in the U.S. alone and the deepest economic downturn in recorded history.
Yet the losses in the banking sector were far smaller than my analysis and, in fact, than the banks’ own loan loss modeling predicted. Today, banks argue that they were a source of strength during the crisis and are once again renewing their perennial calls to relax regulations. Does their performance during the COVID downturn indicate that large banks are strong enough? No, it does not.
The losses in the banking sector were much smaller than expected because governments were so aggressive in providing fiscal support for families and businesses affected by the crisis. In the U.S., Congress allocated almost $6 trillion in COVID-related support programs, which enabled many businesses to stay solvent and families to pay rent, mortgages, car loans, and credit cards, all of which ultimately supported banks’ balance sheets.
Fiscal authorities were right to be so forceful and proactive in supporting the economy during the COVID downturn. But this was also a banking bailout. Absent these fiscal interventions, losses in the banking sector would have been much larger. How much larger?
It is difficult to know for certain, but by comparing this downturn with losses banks faced in prior recessions, staff at the Federal Reserve Bank of Minneapolis estimate it at between $100 billion and $300 billion. These estimates are probably on the low side because, without aggressive government support, it is unlikely that the economy would be recovering nearly as quickly as it is now, and the banks might still be facing losses.
To bring greater transparency to these issues, the Minneapolis Fed has created a tool that allows the public to enter their own assumptions and estimate bank losses under their own scenarios, with and without fiscal support.
We now face some fundamental policy questions. What economic shocks should banks be able to handle on their own? And for which shocks is it appropriate to depend upon taxpayer support?
Most people intuitively understand that the COVID crisis was different than the global financial crisis. The pandemic was essentially a natural disaster hitting the global economy. And banks were no more at fault than airlines or hotel operators.
In contrast, banks had helped to create the conditions that led to the 2008 crisis, having made millions of bad mortgage loans. In neither case would the banking sector, in the absence of government support, have been able to withstand the losses on its own and continue to provide credit to the economy.
In 2008, many large banks faced impending failure, which forced fiscal authorities to step in at the last moment to prevent a banking collapse that could have turned a deep recession into another Great Depression. In the case of the pandemic, fiscal authorities acted aggressively at the outset to support the economy and, in doing so, also rescued the banking sector.
We never know in advance where the next crisis is going to come from, or who will be at fault when it arrives. The only tool we have to ensure banks’ resilience is to make sure they have enough equity capital at all times.
Analysis by the Minneapolis Fed and numerous outside experts indicates banks need about 20 percent equity funding, up from about 13 percent today, to protect against deep economic downturns, such as another housing bust or pandemic.
Banks fight against such proposals because higher equity levels will hurt their share prices. The public must decide: Should banks be resilient on their own or always dependent upon the generosity of taxpayers?