Tuesday, September 29, 2009

Capital replenishments and requirements

How Could So Much Be So Wrong? U.S. Monetary and Fiscal Policies, 2008-2009 (continued)

3. Capital replenishments and requirements

I consider two mistaken policies: (A) The recent emergency infusions of capital and (B) the use of capital as a regulatory guide in general.


Because financial institutions have too little capital relative to their debt, they haven’t been able or willing to provide the credit the economy needs.

Paul Krugman, “Cash for trash,” New York Times, Sept. 22, 2008.

Isn’t it shameful that financial institutions receive capital infusions from the government, and instead of lending it out, they hoard it? I hear this complaint a lot.

Jack Guttentag, “Why banks ‘hoarding’ bailout funds is good,” Washington Post,

Jan. 24, 2009.

The government’s capital infusions to financial institutions were rationalized as help to home-buyers.However, distressed institutions avoided further risky investments. This was desirable as well as understandable, Guttentag wrote: “The justification for the capital infusions is [or ought to be] that they will increase capital, not loans [as critics in and out of Congress complained]. The goal is to avoid future shocks from the failure of undercapitalized firms. The fundamental purpose is to prevent the crisis from getting worse. Other measures are needed to cure it.”


Obviously, the U.S. financial sector’s condition today is excellent. Capital ratios stand at levels we have not seen in sixty years, credit quality has been strong, and innovative financial instruments can spread risks more broadly than ever before…. Supervisory reforms also deserve substantial credit, particularly those aimed at raising bank equity ratios.

Mark Flannery, “Supervising bank safety and soundness,” Federal Reserve Bank of Atlanta Economic Rev., 1st and 2nd quarters, 2007.

It sounds reasonable that, since a bank’s Assets = Liabilities (mostly deposits) + Capital (equity or new worth), large capital relative to assets protects depositors against falls in the value of assets.This simple observation is the foundation of most bank regulation, including the international capital requirements agreed at Basel, Switzerland. There are several problems with the capital approach to bank regulation: (i) The capital measures used by regulators are of doubtful meaning; (ii) however measured, capital has not been a good predictor of bank failure; and (iii) capital cannot be imposed independently of the overall portfolio choice.

Regarding the first, regulators look mainly at book (accounting) rather than market values. This misses the information contained in market prices but is simple because capital requirements are preserved from stock-price fluctuations.

A primary reason for the second problem is that assets are sensitive to economic conditions and can deteriorate quickly. This was evidenced in the recent decline in house prices, as in the falls of agricultural and oil prices in the 1980s and the deflations of 1920-21 and 1929-33. Regulators try to adjust capital needs by the riskiness of assets, but this is difficult for at least two reasons: regulators are not competent to judge risks at any given time except in the most egregious cases, and conditions can change rapidly and substantially.

Third, large capital might be more a consequence of risk that a guarantee of safety. Credibly low-risk operations need little capital to satisfy creditors. U.S. bank capital ratios were high, and so was the rate of bank failures, in the volatile 19th century. Whether increased capital requirements (even if properly measured) reduce risk-taking depends on bankers’ preferences. For a bank that maximizes expected profit subject to a given probability of failure, more capital leaves that probability unchanged as it is directed to risky assets.

The most common message of the Basel Committee on Bank Supervision is that its measures of bank risk have failed – but they’re working on the problem. Never discussed is evidence for the usefulness of the approach even if it could be done.

When Sam Peltzman found that deposit insurance had induced banks to take on more risk, he observed:

Bank examiners devote the greater part of their efforts to a determination of the “riskiness” of a bank’s assets, on the one hand, and the “adequacy” of its capital, on the other…. However, the preponderant emphasis is placed on regulating bank capital rather than the details of the asset portfolio. While there is no specific reason for this emphasis on capital adequacy, it can be explained on institutional grounds. It is surely difficult for a bank examiner to judge accurately the riskiness of the many different asset items he comes across, since they reflect a great variety of [changing] local [and national] market conditions, bank management judgments, and special circumstances. Instead of attempting an independent assessment of these details, a much easier course of action is to accept bank management judgment while substituting for this acquiescence a strong insistence that depositors be protected with adequate capital against the consequences of mistakes.

“Capital investment in commercial banking and its relationship to portfolio regulation,”

J. Political Economy, Jan-Feb 1970.

Nothing has changed. Rules at variance with preferences can still be satisfied without achieving regulators’ objectives (such as reducing risk). The only potentially effective regulation of complex operations must be aimed at results, with penalties for defaulters. Public policies that bail them out do the opposite.