Increased Capital Requirements? Yes!

One of the more interesting arguments against increasing capital requirements from banks was in the June 29, 2009 BusinessWeek (you can find the article online here). Avinash Persaud argues that higher overall capital requirements aren't the solution to the problems of the financial system because such a strategy would fail to take into account the differences among institutions and the different types of risks. He suggests that we should aim to build a system where risk is allocated based on how the financial institution is funded. This suggestion is misguided.

He does make some cogent points. For instance, overall capital requirements might be detrimental to new entrants in the banking field, as new and smaller banks would find larger capital requirements a barrier to entry. This is why if we do increase capital requirements on banks, the capital requirements should scale up as the institutions scale up in size. That way, if a smaller bank collapses and is seized by the FDIC, there isn't as much of a problem. If you have a bank that is TBTF, and can't be seized, you want higher capital requirements so it is less likely to get into such a situation in the first place.

Another point he makes is that raising capital requirements would not help match risk taking to risk capacity. As he correctly points out, risk is not a quantifiable property of an asset. There are credit, liquidity, and market risks, and different parts of the financial system do have different capacities to hedge those different types of risks. However, I would also note that almost all of them failed to hedge such risks when they had the capability to do so. The main problem I have with this argument is that most financial institutions aren't going to hedge the risks that they can best handle if it is more profitable to not hedge those risks. And the reason why is because while these are different risks, those different risks can often mutate into the other kinds of risk.

Liquidity risk, which is a risk all banks have due to the nature of deposits, makes it make sense for banks to have to carry extra capital in case there is deposit flight. For pension funds and insurance companies, however, there is less of an issue with liquidity risk, as they have savings accounts and regular premium payments coming in. Pension funds and insurance companies often are more at risk of a credit risk, where a borrower does not pay them back. Banks hedge against that by diversifying lending, using information they have on borrowers, etc. But all of them are vulnerable to market risk, where some assets will lose value because the economy changes. But all of these risks can mutate into other kinds of risk, just like that.

For instance, market risk causes the value of a stock to plummet. This changes the credit risk on a supplier to that stock corporation, and they are unable to pay the interest due on their bonds. The insurance company has to increase premiums, because now they aren't receiving the interest that was from the credit risk. And that mutates into a liquidity risk for the bank because people end up drawing down their bank accounts, because they have to pay more for their insurance premiums. We live in an interconnected global economy – risk is not simply categorized either. One entity's liquidity risk becomes another entity's credit risk. Lehman Brothers had the liquidity problem which turned into so many others' credit problem, which turned into so many others' market problem.

Last, it is hard to take Persaud's suggestions very seriously, especially when they contain such a bold-faced attack on mark-to-market accounting. Let me translate the following paragraph:

By requiring banks to set aside more capital for credit risks than nonbanks must, regulators unintentionally encouraged banks to shift their credit risks to those who wanted the extra yield but had limited ability to hedge this type of risk. By not requiring banks to put aside capital for maturity mismatches, they encouraged banks to take on liquidity risks they couldn't offset. Moreover, by supporting mark-to-market asset valuations (which make institutions value holdings at their current price) and short-term solvency requirements, regulators discouraged insurers and pension funds from taking the very liquidity risks they are best suited for.

This should read:

When regulators made banks keep more money for credit risks than nonbanks, they made it more important for banks to find suckers who wanted to make a quick buck to make up for their shoddy lending practices. By not making banks put aside money for when their toxic waste blew up, they left banks to bankrupt themselves. Moreover, by supporting mark-to-market accounting and basic ideas of solvency, regulators discouraged suckers in insurance companies and pension funds from buying toxic waste and getting taken to the cleaners as well.

Overall, we need to reduce the size of banks, and increase the capital requirements on banks over a certain size. Those are the only two things that will hedge the risks that we face in this economy.