Capital requirements could hurt banks
Part 1: Preventing another financial crisis
By Jack Guttentag, Monday, March 16, 2009.
(This is Part 1 of a two-part series. Read Part 2.)
While policymakers and their kibitzers, among which I count myself, debate what is needed to cure the current crisis and associated recession, another debate brews in the background. It is about how to fix the system so that it doesn't happen again.
Any coherent proposal for fixing the system is necessarily based on judgments about the causes of the current crisis. While there are many differences in emphasis, I believe that most observers would agree on the essentials: The crisis originated with a bubble in the residential real estate market, followed by its inevitable aftermath of declining home prices, and a subsequent explosion of home mortgage defaults and foreclosures. The resulting losses were worldwide because foreign investors held enormous amounts of U.S. mortgage-related assets. Financial institutions worldwide did not have the capital to absorb these losses, resulting in the collapse of many, and enormous infusions of capital by governments, plus loans and guarantees, to prevent the collapse of many more.
This sequence of events could be prevented by blocking the bubble, or by shoring up the capacity of the financial system to absorb the losses resulting from a bubble's collapse. In my opinion, the second should have priority. We don't know where the next bubble will come from, but if the system has enough capital, a crisis can be averted regardless of its source.
Private financial institutions will never voluntarily carry enough capital to cover the losses that would occur under a disaster scenario. For one thing, such disasters occur very infrequently, and as the period since the last occurrence gets longer, the natural tendency is to disregard it -- to treat it as having a zero probability. In a study of international banking crises, Richard Herring and I called this "disaster myopia."
Disaster myopia is reinforced by "herding." Any one firm that elects to play it safe will be less profitable than its peers, making its shareholders unhappy and even opening itself to a possible takeover.
Furthermore, even if those controlling financial firms knew the probability of a severe shock, and the very large losses that would result from it, it is not in their interest to hold the capital needed to meet those losses. Because they don't know when the shock will occur, playing it safe would mean reduced earnings for the firm and reduced personal income for them for what could be a very long period. Better to realize the higher income as long as possible, because if they stay within the law, it won't be taken away from them when the firm becomes insolvent. ...CONTINUED
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Submitted by Bill Fooks on March 16, 2009 - 3:13am.
Bill Fooks
TFT realty Marketing Service
Warwick, RI http://www.fooksteam.com
Why are the same people who have created the problem now trying to fix it with another dose of over regulation. It seems to me when you force banks to lend to people who can't afford it (Barny Franks call for more lending to minorities to get votes.He must have ment poor people), the government should take the hit for their poor policy. Not the private sector.
Those "know it alls" on capital hill should all be fired.
Submitted by Larry Whited Sr. on March 16, 2009 - 4:49am.
To paraphrase the law of physics; for every action there is an equal reaction.
The excess unregulated Wall Street finical risks of the past few years will cause excess regulation for the next few years followed by an easing that will bring us where we need to be to prevent a repeat. That process may take 8-12 years.
Larry A. Whited, Sr., CRB, CRS, GRI
President & Founder
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West Chester Ohio 45071
Direct - (513) 543-2727 Fax - (513) 297-7497
Submitted by John Rakoci on March 16, 2009 - 5:45am.
More problems ahead as the bailout will need a bailout. Barney Frank and other dems desire for votes provided the legislation to change banking regulations for Clinton to sign. Now that China has put obama on notice to begin thinking rationally we may see something positive from his administration for the 1st time.
Submitted by Joseph Bridges on March 16, 2009 - 5:57am.
As is mentioned with our current system banks will not hold the necessary assets to cover their losses. This would eliminate the leverage principle that is so loved.
Possibly requiring leveraged insurance for banks who leverage to far (up to someone else who says how far a bank should leverage) or just don't bail things out and let the markets take care of themselves.
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Submitted by Anonymous on March 16, 2009 - 7:36am.
Mr. Guttentag,
Why not revert back to Basel I? Or combine Basel's I and II with a higher minimum capital floor? If we insist that future risk-management systems continue to revolve around quant models (that obviously can not predict the future), then there must be a minimum floor at or greater than the original 8%.
--
Joseph,
The problem *is* insurance. The moral decay on Wall Street (that's always been there, made more visible after Glass-Steagal was repealed) was allowed to trickle it's way to main-street with quasi-insurance against defaults through CDS. Whether we insure against institutional leverage or individual transactions, it's the insurance itself that instills the moral hazard that "risk-transfer" brings to society.
Is it any wonder that the CDS market for mortgage-related defaults blew-up from $4 trillion in June-2004 to $62 trillion (notional) by late-2007?
We can not insure ourselves out of this.
Submitted by William Metzker on March 16, 2009 - 9:24am.
While I might partially agree with the conclusion, I do not completely agree to the premise. A condition precedent to the meltdown was too much money looking for a return. Most of this money came from emerging markets (and oil producing states) who had nowhere to put it.
Too much money looking for a place to go has fueled every bubble from tulips to dot coms. If it hadn't found mortgages' it would have found something else.
Thus, it makes sense that too much attention to captital requirements may be counter productive. At the same time, tougher capital requirements may have prevented lenders from leveraging investments at 30-1 ratios. The question is, where's the balance.