published by the Financial Times

Nineteen of the largest US banks received taxpayer capital in 2008 under the troubled asset relief programme and were prohibited from paying dividends. Sixteen of the banks have now repaid Tarp. Most are eager to resume paying dividends and have asked permission to do so from the Federal Reserve.

Some observers argue that it would be unwise for the Fed to authorise dividends before the banks put their financial houses on a stronger footing by raising more capital. They contend that to do otherwise would place the interests of bankers and their shareholders ahead of the needs of the economy.

But is that so? Will allowing profitable banks to pay reasonable dividends from earnings help or hurt the economy?

I have a long record as a “hawk” on bank capital, particularly in large banks. I opposed strongly the Basel international capital accords in significant part because they allow large banks to operate with too little equity capital and discriminate against smaller banks.

Moreover, the Basel risk categories allocate credit away from highly productive uses such as loans to small businesses to less productive uses such as sovereign debt and housing loans (both of which require significantly less capital than business loans under the Basel rules). It is no coincidence we have enormous worldwide problems with excessive loans to overleveraged governments and homeowners.

There are two ways to come into compliance with substantially higher capital-to-asset standards. The fastest is to raise significant new capital (which dilutes existing shareholders). The availability of the new capital will be more limited and its cost will be higher if banks are not allowed to pay reasonable dividends. If banks are not paying dividends, capital will flow to industries that do.

The second way to increase the capital-to-asset ratio is to shrink assets or at least slow their growth and accumulate retained earnings. Banks can accomplish this by being more selective about the loans they make and pricing them higher.

A fair number of banks have already selected the slow growth alternative (either of their own volition or in response to regulatory pressures), which is an important reason businesses are finding it very difficult to obtain credit. The impact is disproportionate on smaller, less creditworthy businesses.

Preventing profitable banks from paying reasonable dividends impedes bank lending and economic growth. It tilts the balance away from the issuance of new capital towards a slow-growth approach.

We made a major mistake in allowing large banks to reduce their equity capital ratios to inappropriately low levels during the boom years. It encouraged lending beyond the ability of capital to cover the risks. At best, we were short-sighted and living on borrowed time (or money).

But we cannot correct this overnight. We should not make a mistake in the opposite direction by driving virtually all risk out of the system, thereby causing further economic damage. A financial system that does not take risks is a financial system that is not supporting entrepreneurship and growth.

Our highest priority today should be to get relatively healthy banks back to lending as quickly as possible. Higher capital standards, which I strongly support, should be phased in over an extended period – say five to 10 years.

We should be careful about declaring what those standards will ultimately be. If, hypothetically, banks currently have 5 per cent equity capital and we announce we want them at 9 per cent within 10 years, market forces will place considerable pressure on banks to get to 9 per cent right away. It would be far preferable to set rolling three-year objectives for individual banks that are not publicly announced by the regulators.

It makes for good theatre to declare that banks are living on the edge and should not be allowed to grow or pay dividends until their capital ratios are raised much higher. But good theatre does not result in increased bank lending to the individuals and businesses that create jobs and economic growth.