Arnold Kling  

The Difficulty of Measuring Bank Capital

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Steven Randy Waldman writes,

he capital positions reported by "large complex financial institutions" are so difficult to compute that the confidence interval surrounding those estimates is greater than 100% even for a bank "conservatively" levered at 11× tier one capital.

Recall that the regulator for Fannie Mae and Freddie Mac reported that they were "adequately capitalized," and not long afterward they had to be taken into conservatorship.

Thanks to Tyler Cowen for the pointer.

[UPDATE: British Tory supports breaking up big banks there.]

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COMMENTS (3 to date)
Chris Koresko writes:

It is my very inexpert opinion that most of our financial troubles are the result of policies put into place to obtain certain social ends (including support of cronies) which broke down market mechanisms which would otherwise regulate the behavior of "large complex financial institutions", and the replacement of those market mechanisms with more regulations designed by people who are not capable of sufficiently understanding those institutions and the interactions between them as they grow and change. The result is unintended consequences and instability.

Is this a reasonable point of view?

Les writes:

There would be no need to calculate capital adequacy for financial institutions if:

a) It was recognized that past regulation was ineffective, and therefore future regulation was no longer required;
b) The customary "too big to fail" mantra was convincingly rejected, and demonstrated by letting the next "too big to fail" institution crash without rescue;
c) Federal deposit insurance was revoked.

Bill Conerly writes:

I was a senior bank officer in the early 1990s, when commercial real estate values collapsed and banks were in trouble (the savings and loan industry having just recently died). I sat in on the committee meetings looking at likely losses on our loan portfolio. I can tell you that educated guesswork is the best you can hope for. And a bank's capital depends on its future loan losses.

The economic forecast--never an exact science--was only the beginning. Would this office building start to cash flow? Was this shopping center in the right part of town to benefit from the recovery? Was this developer's personal guarantee worth spit? We guessed (then called it "analysis" when the examiners walked in).

Today as an economic consultant, I spend more time talking to clients about contingency planning than helping them fine-tune a point estimate, which is what the capital calculation is.

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