Right Objective, Unproven Approach

By Karamjeet Paul

Those calling for higher capital requirements for banks have the right objective of making financial institutions and the system stronger (everybody agrees with that objective). However, their proposals to increase capital don’t receive support from everyone because their approach is not a proven one.

In a New York Times article on August 10, 2014, “When She Talk, the Banks Shudder,” Prof. Anat Admati of Stanford University was quoted as offering an analogy of what’s wrong with banks today: “My comparison is to speed limits. Basically what we have here is the market has decided nobody else should be driving faster than 70 miles an hour and these are the biggest trucks with the most explosive cargo and they are driving at almost 100 miles an hour.”

I assume the key point here is that the large banks are not observing certain limits and are getting away with it, which seems to be what the critics of the current bank capital requirements see as fundamentally wrong. Therefore, they push for a significantly higher – as much as 30% – capital requirements. Actually, this analogy demonstrates what is fundamentally wrong with the argument that more bank capital will save the world.

In the transportation world, speed limits are based upon an accepted and supported-by-evidence model that as the speed goes up lives become at risk. Taking this into account, along with the economic cost of slower driving, a tradeoff is established to designate a speed limit.

In the banking world, however, there is no evidence that higher regulatory capital requirements will necessarily save banks.

If one were to use a highway analogy, then a more correct analogy would be something like this. Lets say for a minute that we didn’t have metrics for the relationship between speed and accident/death rate, nor for the economic cost of slower speeds, but we knew that higher speeds increase the fatality rate. So would you establish a limit of 10 mph to absolutely make sure no one dies of auto accidents? Taken to an extreme, this implies that banning driving altogether would be an obvious solution to eliminating road fatalities.

That’s what pushing for a high capital ratio to save banks implies. However, the 70 mph speed limit is backed up by a metrics and objective data establishing the pattern between speed and fatality rates. No such relationship exists between capital levels and bank failures. No one knows objectively what capital ratio really makes banks strong. So setting an arbitrary high ratio of 30% limit is akin to establishing a speed limit of 10 mph on highways.

It is tempting to think that if all financial institutions had 30% capital ratios, Lehman, Bear Stearns, Wachovia, WaMu and several other institutions would still be around and no financial crisis would have happened in 2008. There are 2 fundamental problems with this view.

One, it assumes that banks can get additional capital or drastically reduce their business activities to achieve and maintain 30% ratios. In the first instance, it is unrealistic to assume that the marketplace would provide additional capital without expecting any incremental return if the capital is obtained only to plug the massive hole between the current capital levels and the 30% requirements if the new capital can’t be leveraged. In the second instance of reducing business activities to comply, banks can say goodbye to the financial markets for future capital if their business growth is severely restricted and must meet the higher cost of 30% capital. Such a reduction implies a bleak future not just for banks, but possibly also for the economy, as banking is the critical backbone of the whole economy.

Problem with this high-capital approach is that it is a static view of the world assuming that banks can get more capital to achieve a 30% ratio and nothing else will change. How will banks get additional capital if they can’t show return on the incremental capital?

Two, let’s assume for a minute that banks can somehow get incremental capital to achieve the 30% ratio. To generate additional return, banks will have to grow their business (which adds risk) without deteriorating their regulatory capital ratios. The only way to grow then is through transactions that earn a high return by taking high risk (the fundamental value added by banks) but in a manner that is so convoluted that the additional risk doesn’t show up in the regulatory formula and thus skirts the limit. In such a situation, transactions will become so complex that most people, regulators included, will have difficulty understanding and comprehending new risks, until a disaster makes them evident (think CDOs, VIEs, CDS, etc. and their veiled risk until 2008). And we will be back to where we started.

This is the unintended consequence of establishing a ratio requirement that doesn’t objectively address what drives the capital requirement in the first place.

Capital is required to cushion the cumulative effect of extreme-tail risk arising from all transactions/portfolios in crises. And, despite all the progress made in managing risk, currently there is no metrics to objectively gauge extreme-tail risk.

So the problem arises not because of the limit and a need to enforce it – actually limits and their enforcement are critical for effective regulations – but because there is no objective metrics to gauge extreme risk and thus the inability to objectively determine how much extreme risk is too much. Such a metrics is urgently needed because the need for greater cushions at banks, measured by any means, is real. But until an objective measure is used to define and capture the magnitude of what causes the problem, simply adding capital is not an effective approach. (See “Current Regulatory Approach Adds Risk to Banks”).

2 comments on “Right Objective, Unproven Approach

  1. Pingback: Right Objective, Unproven Approach | Sustainability Management

  2. Pingback: Plans to Address Extreme-tail Risk Are More Effective Than a Capital Surcharge | Sustainability Management

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