Tuesday, June 28, 2011

Capital Is Political

. Tuesday, June 28, 2011

Joe Nocera and Bethany McLean, co-authors of financial crisis account All the Devils Are Here, have competing op-eds on the importance of raising capital ratios. Here's how Nocera's starts:

Capital matters. Let me put that another way. The current fight over additional capital requirements for the banking industry, eye-glazing though it is, also happens to be the most important reform moment since the financial crisis broke out three years ago. More important than the wrangling over Dodd-Frank. More important than the ongoing effort to regulate derivatives. More important even than the jousting over the new Consumer Financial Protection Bureau.

And here's McLean:

Think about the past (the financial meltdown in 2008) and the present (the fear that a default by Greece will ignite another financial crisis ). If banks had held more capital, would we have avoided either mess? I'm afraid the answer is no.

Here's how I'd sum up the difference. McLean argues that all bank crises stem from runs on banks, and when a run is on no amount of capital can stop it. Yes, Nocera might respond, but runs are crises of confidence and higher capital requirements can increase confidence in the stability of financial institutions. Both could be right. But as McLean hints, the type of capital restrictions can end up backhandedly make financial institutions less safe:

Not only would higher capital requirements have failed to prevent these crises; conceivably they might have made them worse. The risk weighting that the regulators apply to assets encourages banks to hold more of the assets that are supposed to be low-risk. That's why banks all owned a lot of mortgage-backed securities—they were purportedly low-risk, and banks didn't have to hold much capital against them. Sovereign debt like Greece's was also purportedly low-risk; that why banks owned a lot of it. Subsequent events showed that the risk weightings left something to be desired. Because they were standardized, they incentivized banks engaged in the same risky behavior. If you believe that crises come about because too many banks do too many of the same dumb things, then faulty international capital requirements are arguably worse than no such requirements at all.

This is more-or-less the Friedman hypothesis [1, 2, 3, 4]: the regulatory code rewarded lending to governments and to vehicles for securitization, and no wonder. Regulations are political creations, so they will favor things that political actors want. Cheap access to government debt is one; plenty of cheap housing finance is another.

Nocera hasn't fully internalized this point -- he refers to regulators' decisions as "somewhat absurd" and to political bargaining over regulatory policy as "pathetic" and a "sorry sight" -- but he hones in on one important international dimension:

European banks, to be sure, have fought fiercely against higher capital requirements. It’s not really because they hope to get a leg up on the rest of the world, though. It is because these banks are in far worse shape than the banks in other parts of the world; they can’t afford higher capital requirements. If Europe began insisting that its banks begin holding enough capital to cushion against all the risk on their books — starting with Greek debt — the truth would be out: Their insolvency would suddenly be apparent. If Europe wants to keep kicking the can, by turning its back on the surest measure to increase the safety of its financial system, why on earth would we want to go along?

Tarullo will soon travel to Basel, Switzerland, (yes, that’s why they call them the Basel accords) to push for the highest capital requirements he can get the rest of the world to agree to. He will also try to convince the international standard-setters that a significant surcharge on the most systemically important banks is vitally important.

That surcharge, discussed here, represents just the most recent of several US (and UK and Switzerland) victories in the Basel negotiation process. The delayed phase-in was the main victory of the European contingent. But the takeaway needs to be that we need to understand the political process in order to understand what the purpose of regulations are, and the ways they shape firm behaviors.


Capital Is Political
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