Mark Gritter (markgritter) wrote,
Mark Gritter

Capital requirements

From a Slate article arguing that higher capital requirements wouldn't have prevented recent financial crises comes this interesting idea that such requirements actually increase risk:

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 [sic] 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.

Or to put it another way, the regulations (and rating) caused all the banks to take on correlated risks, instead of diversifying. (On the other hand, the article really does not get into the obscene amounts of leverage that were being applied, and the risks of doing so.) If one bank got into major trouble, other banks were likely to be holding the same assets. I'm not sure transparency or the other "ideal world" regulations the article suggests would alter this, though.

If your goal was to prevent systemic risk, what sort of regulations would encourage diversity of bank assets? Having one or two banks fail is OK--- having them all run short of capital simultaneously is what we'd presumably like to avoid.
Tags: finance
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