Arnold Kling  

Capital Mis-Regulation

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Kevin Dowd and others have written a lengthy, important paper on the flaws in the Basel capital regulations. They write,


The Basel system provides a textbook example of the dangers of regulatory empire building and regulatory capture, and the underlying problem it addresses -- how to strengthen the banking system -- can only be solved by restoring appropriate incentives for those involved.

In my opinion, the capital regulations provide a textbook example of the dangers of regulatory hubris and the belief that you can make a financial system too regulated to fail.


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COMMENTS (2 to date)
Vangel writes:

I agree. The fools who came up with the Basel rules created a situation in which the so-called 'good banks' are in big trouble because they were told to load up with 'safe' sovereign bonds. But the market recognized that bonds issued by Spain, Italy, Greece, Ireland, or the UK are not very safe. That has brought the banks on the brink of insolvency.

Mike Rulle writes:

The essay is good review of the history of recent bank regulations, although nothing new was written. In particular, it higlights the remarkable business that came to be known as regulatory arbitrage. The authors are also spot on that banks wanted risk based capital to give themselves the option of how much capital they truly wanted.

I do wish authors would stop using gross numbers when quoting derivatives---no one does this for listed futures markets because it would be seen as the foolishness that it is. All derivatives and repos inside the banking system are zero sum and ultimately net to zero. It is only those made outside the system which create incremental risk to the banking system as a whole. Distinctions need to be made
here. AIG is outside the banking system, so that was true
banking system risk----but that was 400bil notional (authors
use 60 trillion CDS as global market). For what it is worth, it is
my understanding that AIG's super senior CDS positions as of
one year ago had virtually zero defaults.

One other thing that bothers me is saying that LTCM was
bailed out. Perhaps someone can correct me, but I believe
that, ironically, Greenspan played a similar role in 1998 as J.P.Morgan did in 1907. (Authors also neglect to mention that
after that experience, Morgan and others pushed for a Fed
like entity). Greenspan coerced the banks to form a "club" to
unwind LTCM. I do not recall any government money or implied guarantee being proposed. If wrong, please
correct me.

The authors leave out one group for criticism, as many do
when discussing the crisis, and that is shareholders themselves. In theory, through their elected board members,
they are there to check the natural self interest of
management against investors. Somehow, this system does
not work. This critique holds true for all industries. The
authors also imply this by comparing public shareholders
unfavorably with previous private partnerships.

It is unclear to me why, despite Basel's existence,shareholder groups could not have been more active in punishing banks,
through selling, for taking too much risk, or without Basel, why we should expect them to be more diligent in the future. Management has perfected the art of taking advantage of shareholders and bondholders primarily because of the moral hazard of bailouts. Letting institutions fail will certainly clarify the mind for any future activities.

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