Capital requirements (usually something like "a minimum of 10% of the bank's balance sheet has to be funded by equity or deferrable bonds") are far more important to a bank than reserve requirements:
- if bank capital is too high, return-on-equity is lower for a given amount of profit. Hence shareholders don't want too-high capital
- if bank capital is too low (from too many non-performing loans) then the bank will need recapitalisation which is expensive and bad for shareholders, and if it can't get that, it will be wiped out (either lose its licence or get bought out/nationalised/gutted)
So banks are incentivised to not create debt that is too-risky -- i.e. where the ratio of potential non-performing loans is too high for the interest rate they lend at, or the interest rate of raising expensive additional capital would get too high...
Reserve requirements are about liquidity (bank runs) rather than about solvency - but if bank capital can be ensured to be positive and the bank remains solvent, bank runs are much less likely in the first place, and liquidity provision and bailouts to avoid bank runs won't incur losses for the rescuing entities.
> So banks are incentivised to not create debt that is too-risky -- i.e. where the ratio of potential non-performing loans is too high for the interest rate they lend at, or the interest rate of raising expensive additional capital would get too high...
Thereoretically yes. However, 2008 moral hazard (heads I win, tails you lose) of excessive mortgage lending and securitisation put paid to that notion. Staff of bailed out banks were getting their bonuses again in 2009[1].
It also touches on the principal/agent problem, where bank executives and traders don't really care if the shareholders get wiped out and the taxpayer picks up the tab. They'll get their bonus and bounce to the next opportunity if the bank itself goes belly up.
Additionally, the Justice Department refused to bring criminal charges against bank exectutives[2].
So, you'll load up on risk to make excess short term profit, maybe your bank will go bust, but you'll never face charges and may get a nice bonus next year at your bank, or bounce to the next bank. Must be nice.
Is this different from setting the maximum risk to capital ratio to infinity?
If not, won't we have worse cycles of mania and panic? And what would stop banks from eating the world, through unfettered debt creation?