Capital requirements: Why they wouldn't have prevented our most recent financial crises.

Commentary about business and finance.
June 23 2011 11:58 AM

Capital Punishment

Why stricter capital requirements wouldn't have prevented our most recent financial crises.

(Continued from Page 1)

Today, the worst-case scenario is that a Greek default will ricochet through the system in much the same way that the collapse of Lehman Brothers did. It'll increase the pressure on other debt-burdened countries, like Ireland, Portugal, and Spain. That in turn will affect European banks that own those countries' debt. (Already, Moody's has put three French banks on review for downgrade because of their exposure to Greece.) One way the panic could spread to the United States is through our $2.7 trillion money-market industry, which has a hefty percentage of its assets—44.3 percent, according to the latest study by Fitch Ratings—in European bank debt. If this debt is at risk for a downgrade, then the money market funds will have to start selling, because they're only allowed to hold highly rated debt.

Greece's problem (and Ireland's, and Portugal's, and Spain's) is that it has too much debt. But if this worst-case scenario plays out, the European banks' main problem will be that three years after the 2008 meltdown they're still relying on an unstable source of funding. (The Investment Company Institute, which is the trade association for the mutual fund industry, says everything is under control. Market participants aren't so sure, which is why one source of mine says about the capital debates, "The technocrats are fiddling while Rome burns.")

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.

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If banks had more capital, wouldn't they take less risk, because the bankers would have more to lose? I'm not sure the answer is yes, because the capital is still other people's money. A better argument in favor of stricter capital requirements is that if there were more capital and less debt in the system, then the likelihood would diminish that short-term lenders and depositors would get scared enough to create a run. But in the gigantic, murky, interconnected world of global finance, I'm not sure there's any amount of capital—any amount that still allows the system to function, that is—that would provide enough comfort under all circumstances.

In an ideal world, we would do a lot more than require banks to hold more capital. We'd mandate transparency in the valuation of their assets, so that outsiders had a prayer of knowing what the stuff on banks balance sheets was actually worth. We'd force banks not to rely on short-term funding, so they couldn't have a liquidity crisis. And we'd make sure that regulators understood all the unique risks in each institution that they were regulating.

But none of that is going to happen. So maybe requiring more capital is the best we can do. But we should be aware that it's an imperfect solution, and that getting the details wrong risks creating catastrophic problems down the road.

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