by From Lars Syll A couple of years ago, former chairman of the Fed, Alan Greenspan, wrote in an article in the Financial Times, re the increased demands for stronger regulation of banks and finance: Since the devastating Japanese earthquake and, earlier, the global financial tsunami, governments have been pressed to guarantee their populations against virtually all the risks exposed by those extremely low probability events. But should they? Guarantees require the building up of a buffer of idle resources that are not otherwise engaged in the production of goods and services. They are employed only if, and when, the crisis emerges. The buffer may encompass expensive building materials whose earthquake flexibility is needed for only a minute or two every century, or an extensive stock of
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from Lars Syll
A couple of years ago, former chairman of the Fed, Alan Greenspan, wrote in an article in the Financial Times, re the increased demands for stronger regulation of banks and finance:
Since the devastating Japanese earthquake and, earlier, the global financial tsunami, governments have been pressed to guarantee their populations against virtually all the risks exposed by those extremely low probability events. But should they? Guarantees require the building up of a buffer of idle resources that are not otherwise engaged in the production of goods and services. They are employed only if, and when, the crisis emerges.
The buffer may encompass expensive building materials whose earthquake flexibility is needed for only a minute or two every century, or an extensive stock of vaccines for a feared epidemic that may never occur. Any excess bank equity capital also would constitute a buffer that is not otherwise available to finance productivity-enhancing capital investment.
That is — to say the least — astonishing. Not wanting to take genuine uncertainty or ‘fat tails’ seriously is ominous enough. Is there anything the year 2008 taught us, it is that the ‘tail risks’ are genuinely real and must be included in all financial calculations. But even worse is how someone — who surely ought to have read at least an introductory course in economics — can get the idea that demand for higher capital requirements of banks would be equivalent to building buffers of ‘idle resources.’ The claim is from an economist’s point of view absolute nonsense.
Capital requirements are about how the mix between debt and equity of banks’ balance sheets should look like. It is not a question of something having to be set aside. It is not about liquidity or reserve requirements. Capital requirements are not about pea soup in a jar that we should put on stock to have in a crisis. It’s about how much leverage we should allow banks to have.
Higher capital requirements simply mean that we demand that banks finance a larger portion of their portfolios out of equity and less out of money deposited or loans. There is nothing here about resource use, but about how banks should manage risks. And how they are distributed in an economically efficient manner.
Of course, higher capital requirements mean that banks’ risk-taking decrease. It is precisely because of this the requirements have been instituted. We saw in the recent financial crisis how the ‘systemic risk’ shot up when the banks were found to have taken on too great risks. Financial institutions authorized to operate with high leverage generate negative externalities. Of course, we have to — in the light of the financial crisis — ensure that banks operate under less leverage. Higher capital requirements are one way of achieving this.
Let me illustrate the mechanism.
Suppose a crisis would come and there would be a loss of 1 million USD, and the bank’s own capital is, for example, 5% of the balance sheet, that would force the bank to liquidate assets at a value of 20 million USD to regain the 5% level. Obviously, systems repercussions would be monumental. Higher capital requirements would both reduce the risk of liquidation, and the repercussions would be smaller (20% equity level would, in our example, reduce leverage to 5 million USD).
Suppose the initial balance sheet looks like this:
Loan: 100 Shareholders’ equity: 5
Liabilities: 95
Now if you raise the capital requirement from 5% to 20%, the bank can in principle react in three ways:
A: Assets Liquidation
Loan: 25 Equity: 5
Liabilities: 20
B: Recapitalization
Loan: 100 Shareholders’ equity: 20
Liabilities: 80
C: Assets Expansion
New assets: 12.5
Loans: 100 Shareholders’ equity: 22.5
Liabilities: 90
In both cases B and C it is evident that the higher capital requirements do not mean that the balance sheet must be reduced. Banks can continue to provide the economy with the necessary loans. Some negative effects on the banks’ ability to perform their basic system functions need not occur because one raises the capital requirements.
This is basics. That a former Federal Reserve chairman does not understand this is, to say the least, disheartening.
But maybe that is how it goes when you prefer reading Ayn Rand to Keynes or Minsky …