How much equity does a bank need?

15-20%, says Sebastian Mallaby in an article in the FT. The Basel 3 norm of 7% core equity is not enough, he says. His argument is as follows:

Three factors drive this estimate. First, recall how much equity can be destroyed in a crisis. The International Monetary Fund calculates that credit losses at US banks between 2007 and 2010 amounted to 7 per cent of assets, so banks must be in a position to lose that much again and survive. Second, consider how much residual equity banks must have left after a large hit. Here the answer is about 8 per cent of assets – that is the amount that the top four US banks felt it necessary to hold in early 2010 in order to retain market confidence. Third, remember that capital is held against risk-weighted assets, and that the calculation of risk weights is notoriously treacherous, so banks should hold a further buffer against “model error”, aka geeks who screw up. Adding these factors together, a 20 per cent equity capital ratio seems reasonable, even if some of this may take the form of “coco” bonds that convert to equity in a crisis.

Mallaby dismisses the argument that more equity will mean a higher cost of capital for banks. He says as more equity is raised, the cost will fall because banks will be perceived as becoming safer. Swiss regulators have already imposed a requirement of around 20% on UBS and Credit Suisse if one includes convertible debt. Mallaby argues that, in order to prevent regulatory arbitrage, shadow banks too must be subject to minimum capital and other requirements.