Arnold Kling

One Ply Look-Ahead

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Jacopo Carmassi, et al write,


the key to avoiding repeating this crisis is setting adequate capital requirements that cannot be circumvented for all intermediaries able to raise funds redeemable on demand at par. The simple way of doing it is to set capital requirements with reference to total assets, with no further distinction - 8% should be 8% in cash and equity, with no gimmicks allowed. All risks effectively borne by a bank, regardless of their legal attribution or geographical location, should be included in the asset definition, and accounting principles should be modified accordingly.

Thanks to Mark Thoma for the pointer.

The authors of this article understand the role that excess leverage played in the financial crisis. However, they have no feel for the chess game of financial regulation. If you went with a fixed ratio of capital to assets, regardless of the risk of the underlying assets, what move would the banks make in response?


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COMMENTS (9 to date)
Matt C writes:

My feeling, arguing about which new regulatory policy would fix everything is a little silly. TARP and the other bank giveaways show us who the policymakers are really concerned about. We got a lot of promises after the S&L scandal. We got more after Enron. We'll get more now. Don't mean nothing.

I admit it is interesting, in an academic way, to discuss policy details that might work if the foxes weren't running the henhouse. And it's not very interesting to say "no matter what you do, in 20 years or so the financial industry will run a new grand scam and screw over first their investors and then the taxpayers". But I think it is more accurate.

Russell writes:

Sometimes I think the chess analogy, while illuminating, is misleading. Unlike in chess, banks and regulators can (analogously) flip the board over if they're losing or simply change the game to checkers.

John Thacker writes:
If you went with a fixed ratio of capital to assets, regardless of the risk of the underlying assets, what move would the banks make in response?

An excellent point. The answer you're looking for is that the banks would eventually respond by holding as risky assets as possible.

E. Barandiaran writes:

It's amazing the number of people that write or talk about banks and their regulation with little knowledge of the history of banking, the history of public debates on banking, and the history of academic analysis of banking. From the history of banking they will learn how close the relationship between banks and governments has been in the past thousand years. From the history of the debates on banking they will learn how often the purpose of government intervention has been to secure low-cost financing to government's protected interests. From the history of academic analysis, they will learn how often the analysis has been based on the false assumption that a benevolent government can contain the risks taken by private banks funded by deposits. These lessons may be easier to draw from Europe's experience than from US's, but everywhere banking systems have been the creation of nonbenevolent governments rather than free enterprises. Banking crises are often the result of large and abrupt changes in the type of government intervention--from "too tight" to "too loose". After a crisis we can try to limit the practices that have caused or at least precipitated it, or we can make the mistake of returning to a "too tight" system.

Patrick writes:

I think John Thacker nailed it. This is the biggest problem with reserve requirements. You can always take on an asset of the same value but double, triple, whatever your hedging and make it all the riskier. If someone owns $30 billion in sketchy mortgages and you raise the capital requirements, they can just set up some hedging and derivative contracts and own $10 billion of securities that run 3X the market price. If you set reserves based on riskiness of assets, they can just daisy chain small pieces of very risky assets until they - theoretically - aren't risky anymore. I do believe it's better to not link reserves to "riskiness" because it basically creates an incentive to hide information about your assets.

At the end of the day, the owners of these assets need to be the ones liable for them.

Dan Weber writes:

(I think you copied the URL from Google's short-cut, not from the actual article. Try http://www.finreg21.com/lombard-street/the-chess-game-financial-regulation instead of http://www.finreg21.com/.../the-chess-game-financial-regulation.)

[Thanks, Dan! I've modified the links, correctly, I hope.--Econlib Ed.]

Instead of a fixed ratio, wouldn't a counter-cyclically adjusted ratio make more sense? I.e., as the economy grows faster, capital requirements are gradually raised, and then reversed as the econom slows?

8 writes:

Sell the assets to buyers who do not have capital requirements.

kebko writes:

The best idea I've heard is to require a certain percentage of the banks' assets to be leveraged through subordinated, tradeable bonds. If the bank goes under, the bondholders are the ones who take the hit. But, likely it would rarely get to that point, since banks that leveraged too highly would start to see their bond prices collapse & other banks with less leverage would come in to buy their assets at a discount. I'm no banking expert, but I don't understand why this isn't done already. It seems like the subordinated bondholders would serve the role of the FDIC.

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