Monday, July 6, 2009

Basel's Revenge

. Monday, July 6, 2009

Takafumi Sato, the commissioner of Japan's Financial Services Agency (the main regulatory agency in Japan) argues that stricter capital adequacy requirements for banks would not have prevented the present crisis. Indeed, he argues, they may have caused it:

I share the determination to prevent a repeat of the financial crisis. I also believe capital adequacy regulations have a key role in our prevention efforts. Medicine, however, should be prescribed properly, as any effective medicine has side-effects as well. Suppose stronger regulations make banks issue more equity. Then the capital market will expect greater profits in return, and bank management may be tempted to meet such profit pressure by taking more risks. Was this, however, not the cause of the catastrophe?

Also, bigger capital requirements may induce complex risk-taking. If bankers add simple risks, regulators will notice and request more capital. In order to satisfy both regulators’ demand for a high capital-to-risk ratio and investors’ demand for return on equity, bankers may want to take risks in a sophisticated manner, inventing exotic products and creating a darker shadow banking system. It would be too optimistic to presume that we can stop this completely.

The most elaborate shadow banking system flourished in the US, the jurisdiction with the world’s most demanding capital requirement – 5 per cent of so-called “tier 1” capital over total assets. “Excess is as bad as shortfall,” said Confucius. Shortfall in bank capital indeed destabilises the financial system. Many banks’ capital bases need to be strengthened and we should fortify capital adequacy regulations. However, excessive capital requirements can result in a big banking system making big profits by taking big complex risks, defeating the whole purpose.

This follows a common theme at IPE@UNC: the exotic financial instruments at the root of this crisis were created to give banks opportunities for risk-taking. There is no other reason for their existence. The general response to this observation is to advocate even stricter regulations to prevent this sort of regulatory arbitrage from recurring. But as Sato says, "it would be too optimistic to presume that we can stop this completely". Nor is it even obvious why we should. Capital adequacy standards were created to strengthen systemic stability, not to weaken it. If strict capital adequacy ratios incentivize bankers to take less transparent risks, then perhaps our regulatory system should focus on improving transparency rather than mandating a higher number.


Basel's Revenge
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