Top Finance Experts To G20: The Basel III Process Is A Disaster

By Simon Johnson

The Group of 20 summit for heads of government this weekend will apparently “hail bank reform,” particularly as manifest in the Basel III process that has resulted in higher capital requirements for banks. According to leading authorities on the issue, however, the Basel process is closer to a disaster than a success.

Bank capital can be best thought of as the amount of financing of a bank’s operations (lending and investment) that is covered by equity and not by debt obligations. In other words, it describes how much of the assets of the bank are subject not to the “hard claim” of debt but rather to a residual or equity claim, which would not lead to distress or insolvency when the value of the asset goes down. For global megabanks, equity capital is thus a key element in preventing the failure of an individual institution (or a couple of banks) from bringing down the financial system.

The framing of the Basel “success,” according to officials, is that the big banks wanted to keep capital standards down — and this is definitely true — but that governments pushed for requirements that are as high as makes sense. The officials implicitly conceded the banks’ main intellectual point, that higher capital requirements would be contractionary for the economy.

But according to top academic experts on this issue — people who know more about banks and bank capital than anyone else on the planet — the banks have misrepresented and the officials have misunderstood reality.

In a letter published in The Financial Times this week, Professor Anat Admati (Stanford University) and her colleagues — a Who’s Who of finance — make three main points.

First, the basic economics behind official thinking is wrong.

“Some claim that requiring more equity lowers the banks’ return on equity and increases their overall funding costs,” thus lowering economic growth, the professors write. “This claim reflects a basic fallacy. Using more equity changes how risk and reward are divided between equity holders and debt holders, but does not by itself affect funding costs.”

They go on to say: “High leverage encourages risk taking and any guarantees exacerbate this problem. If banks use significantly more equity funding, there will be less risk-taking at the expense of creditors or governments.”

Second, the Basel process uses dysfunctional methods to adjust capital requirements to reflect the risk of various kinds of assets.

“The Basel accords determine required equity levels through a system of risk weights,” they write. “This system encourages ‘innovations’ to economize on equity, which undermine capital regulation and often add to systemic risk. The proliferation of synthetic AAA securities [around U.S. housing loans] before the crisis is an example.”

Third, capital requirements should be simplified and greatly increased — relative to what the Group of 20 leaders will congratulate themselves on.

“Lending decisions would be improved by higher and more appropriate equity requirements,” they say.

And they are also completely on target with regard to the political economy problem here: “Many bankers oppose increased equity requirements, possibly because of a vested interest in the current systems of subsidies and compensation. But the policy goal must be a healthier banking system, rather than high returns for banks’ shareholders and managers, with taxpayers picking up losses and economies suffering the fallout.”

This is not extraordinary language per se — you can see the same sentiments, for example, echoed throughout the new movie “Inside Job” (which I highly recommend, as does the reviewer for The New York Times; disclosure, one sound bite from me appears in the movie). And I have advanced similar views on this blog over the past 18 months (e.g., see this post).

But to have the intellectual leaders of the finance profession weigh in so heavily and with such language is huge. Officials claim that they are the custodians of best practice in economics. If you criticize them on this or any other issue, they will roll their eyes — implying you do not understand reality or the insights of the truly deep thinkers.

So here are the deepest thinkers — founders and mainstays of the entire field of finance — finally standing up and saying: Enough of this nonsense. You may wish to pretend that keeping capital requirements low is a good idea, but you should understand that this is pretense and bad science, pure and simple.

Remember that most productive firms in our economy are financed with equity — shareholding is at the heart of the American economic model. Bankers make it sound as if something is wrong with being equity-financed, but all these big banks are publicly traded in any case. They just need to raise more equity and rely less on debt. This would not be difficult — and definitely not disruptive to the nonfinancial “real” part of the economy.

There is no intellectual case for the Basel process on its current basis or for the outcome that will be discussed this weekend. The Group of 20 leaders are kidding no one but themselves when they endorse this approach.

The Group of 20 has completely failed to do what is necessary to rein in global megabanks — and to make them safer.

Listen to the leading minds of the finance profession and take corrective action now, before it is too late.

An edited version of this post appeared today on the NYT.com’s Economix; it is used here with permission.  If you wish to reproduce the entire post, please contact the New York Times.

35 responses to “Top Finance Experts To G20: The Basel III Process Is A Disaster

  1. Prof. Johnson. This is a veritable endorsement of the assessments and opinions you have voiced since early on in the financial crisis. Congratulations, and keep it up!

    If like-minded people now use this actively to change opinion among policy-makers, then maybe we could hope for a Basel 3.5 or a positive shift in national regulations (especially in the US).

    More likely, things will muddle on as before.

  2. Congratulations for the post, enlived by seasoned reason.
    It would be great if Prof. Johnson could turn his
    students to do some ‘fieldwrok’to estimate the approximate percentage of insolvent banks as of today.
    It brings to mind a comment in an addendum Nessim Taleb
    made recently to his opus magnu, in a chapter called
    ‘Ten lessons to live in a black swan world’, noting:
    ‘In the U.S, in the 2000s, the banks took over the governement. This is surreal’
    Adair Turner must be boiling of old anger, as the G20 had tasked the F.S.B specifically to this end. When one has followed have the horse-trading at work to reach the final Basel III agreements, the original B.I.S process contain somme sensible suggestions, one can suspect that the bloody I.I.F with the help of Mr Trichet managed to ‘capture’the B.I.S regulators, Such procrastination on the oversight of ‘systemic risk’ and SDIs should be made accountable,
    instead of the taxpayer.
    When you add to that that the proposed European cross-border resolution authority, to be operated out of Brussels, is to be chaired by Mr Trichet, and is to include approximately 60 members, imho every European central banker and his wife, pessimists would easily reach the saddening conclusion that cronyism in the financial sector has taken over the world governance.
    Btw, It would be great to ask either rhe L.S.E or Adair Turner for permission to reprint his text for this blog and its purpose, along with yours. That publication also got mysteriously watered down by the mainstream financial press, no wonder !

  3. CBS from the West

    Help me out here. Why would greater equity requirements reduce banks’ appetite for debt? That would make sense if the people making the investment decisions, i.e. management, were themselves major shareholders. But, as I understand it, management generally has only minor personal stake in the soundness of their banks.

    First, they still can rely on government to bail them out when things collapse. Even if we assume that governments really will let the banks fail, does that actually affect the well-being of management if they are not major shareholders? I think not. The modern corporate model seems to be that management comes in and loots the corporation as thoroughly as they can without waking up the sleeping shareholders. They do this with the complicity of their boards of directors. And they do it secure in the knowledge that when the corporation finally fails, they will be among the first in line with their golden parachutes to pick the remaining scraps of flesh from the carcass. Then they call their cronies to get new jobs looting other firms.

    I know the above model is something of a caricature, but only slightly so. I fail to see how increased capital requirements will make banks less risk-seeking unless management are forced to substantially share in the risk personally.

  4. I worked at a large bank outside the US when Basel II was being implemented. The project cost over $200mm (if I were to convert to USD) and I’m sure the real total cost was significantly higher. We were pretty good at projects but the Basel work was a mess. A large part of the complexity was interpreting the risk weighting and how to apply it. A lot of debate over how “innovative” we could be, to use the wording from above. In the end, I’m now sure how much safer the world was – our capital requirements were more or less the same.

    It seems governments are all too willing to accept very complex regulations that drive huge costs, but in the end are of questionable value. Sarbanes-Oxley would be another obvious example of this.

  5. Heh, there’s a shocker of a headline. Don’t think I need to read the details. Hey Professor Johnson, at least this should get Kurowski off your back for like, what, 24 hours??? (hahaha).

    That was quite a list in the Admati letter too. Fama was on it. I’m glad Fama is on the good guys team here, but frankly, mildly surprised. It’s not the stance I would expect from him. Nonetheless he chose the right team intellectually and morally.

  6. Sorry: this is off-topic for this thread. There are rumours in the WSJ and elsewhere that the IMF might be offering Ireland an IMF-only intervention on more favourable terms than the EFSF’s. Dr. Johnson, would you like to comment on these reports? It would be very interesting to hear your thoughts on what may be going on, and what the political backstory could be.

  7. Has anyone else seen “Inside Job” yet? Academic experts in finance don’t come off too well, and that is an understatement.

  8. Great post Simon. Yves Smith is too busy to perform takedown duty on Vikram Pandit’s Column in the FT today (“Basel III will kill small businesses!!”) – come on, you know you want to!

  9. George999,
    Gee, I would have thought Vikram Pandit would have been too busy trying to kill good journalism together with WordPress, to find the time to hand FT more big bank propaganda. See these two links by Doug Henwood:

    http://lbo-news.com/2010/09/24/citigroup-feels-violated/

    http://lbo-news.com/2010/09/24/citi-update/

    Besides, I thought FT already had their own bank executive transcribers working fulltime on big bank propaganda. “Highly shreddable” indeed…. Hope FT has enough bank advertisement space leftover with all that.

  10. This is the letter I sent to the Financial Times referring to the letter of Adnat Amati and colleagues, which will of course not get published, and for Simon Johnson to now say “I have advanced similar views on this blog over the past 18 months” must be a joke.

    Finally some real heavy-weight support!

    Sir at long last an important number of academicians are speaking out asking to remove “the biases created by the current risk-weighting system” imposed on the world by the Basel Committee on Banking Supervision for the purpose of determining the capital requirements of banks, “Healthy banking system is the goal, not profitable banks” November 9.

    The hundreds of letters related to this issue that I sent to the Financial Times over the last five years, and that were ignored, will serve as proof of the immense difficulties of fighting a regulatory paradigm that sounds so extremely logical as capital requirements based on (ex-ante) perceived risk does, but that is still so utterly faulty. In fact it has proven even more difficult than making Citi’s Charles Prince stop dancing.

    I hope that the fundamental revisions to the financial regulations, when they come, as they sure will come, will also include the need of avoiding the trap of placing important regulatory issues in the hand of non-transparent mutual-admiration clubs like the Basel Committee which are not diversified sufficiently so as to avoid the risk of degenerative intellectual-incest.

    By the way, just for additional clarity, I wish the title of their letter had said “Healthy and useful banking system is the goal”, but again I am more than glad enough.

  11. Bruce E. Woych

    I was so overwhelmed with the enthusiasm of your presentation that I almost lost track of the fact that the actual news is not all that optimistic and the banks do appear to be leveraging things on their own terms anyway.

    On the initial impulse, however, this is an incredibly well positioned statement and clearly presented so that the average person can follow it.

    On the other hand, where in the world have these titans of economic wisdom been all along? This deux ex machina is a dramatic entry indeed. Hopefully we will hear more from these Stanford authorities? If not…Why Not?

  12. Bruce E. Woych

    http://en.wikipedia.org/wiki/Sarbanes%E2%80%93Oxley_Act

    It seems governments are all too willing to accept very complex regulations that drive huge costs, but in the end are of questionable value. Sarbanes-Oxley would be another obvious example of this.

    http://en.wikipedia.org/wiki/Sarbanes%E2%80%93Oxley_Act

    Speaks for itself>

  13. Bayard Waterbury

    Simon, I wholeheartedly agree, as usual, but then, the only disagreeable parties are likely to be the “insider’s club members” who don’t want any change, let alone a change which could hurt their bonuses and stock values. Of course, this is only one of many issues which affect the same overall problem: be biggest banks get favorable treatment under every conceivable circumstance. Sure, guys like Goldman have paid so fines which, in the normal world, would be considered horrific. Sadly, though, they did so to avoid any admission of culpability, I guess theoretically to avoid the hefty legal fees involved in a multi-year investigation, pre-trial and trial. But, to have paid less than the penalties paid, they must have perceived that either (a) they were going to pay attorneys hundreds of millions, or (b) most likely, in the end, they would lose and suffer not only the fines, but also the embaressment of being humiliated.

    Yes, capital requirements are great, especially, as you indicate, if they must be in cold hard equity and not in pliable (new accounting rules) debt assets. But then again, without strong enforcement of the Volcker Rule, and other enforcement which seems so anemic, the equity requirements, regardless of how strong, won’t stand in the way of the endless churn they get in their casino pits.

  14. if everyones checking, saving, and retirement accounts(which have already been depleted since they dont have no damn jobs) suffer from the money losing it’s value, that’s ok as long as we can continue to export our cows and american cars

  15. Your first mistake was sending letters to FT. You might try a media outlet which doesn’t dance to whatever rhythm the large banks choose to play. When the large banks select a song in the jukebox FT says “Oh what a coincidence!! That is my favorite song also!!!”

  16. Prof Johnson,

    The academic experts are right in saying that the BII (or III) risk weighted capital process can have lots of unintended consequences and may very well lead to a more procyclical banking system than one without dynamic risk weighting (example: in a recession, the average firm’s credit rating worsens and as a result the firm’s lender faces a choice between three things: reducing his unweighted exposure, allocating more capital to the loan or improving the loan’s structure (in a way that reduces the unexpected loss and not only the expected loss). Typically the bank will be at least more reluctant to finance the temporary expansion of the firm’s working capital, hence making firms ion general more cautious than they would normally be). To what extent increasing the capital requirement (under III relative to II) whilst maintaining the dynamic risk weighting aspect would contribute to additional borrowing costs is not only a matter of finance (of course it would not by itself change the cost of borrowing for end users of credit: finance 101) but also of market structure. Banks design strategic responses to regulation and they rarely do that in a fratricidal way, for the simple reason that having the capacity to conduct risky business under some informal gvt commitment to their creditors that banks who comply will be bailed out, will always drive banks to seek returns using this free option to put their failures to the state, and not their creditors. Also, it is an industry where costs are traditionally transferred to customers with low bargaining power. So it may well be that the public will experience a general cost increase, but without a simultanuous wealth transfer to bank shareholders. More likely would be an increase in managerial benefits.

    However their critique of Basle III leaves out two important points: (1) the rationale for an international capital adequacy regime (and the associated extension of this regime to insurance- and securities firms) was primarily the creation of a level playing field (2) controlling the externalities of the financial system (cyclicality effects, systemic risk, large, but not systemic bail outs) would not have required such a system. The regulators were also completely outgunned by well supported ISDA campaigns proposing to adopt simplistic finance approaches to very complex problems. In that respect it is interesting to seen some of the names associated with a large body of financial theory invoked by the ISDA practitioners as signatories.. However if the main goal had been to construct a safe system from the taxpayer’s point of view, a combination of restrictive licensing and proven (rather than prototyped) supervision approaches would have sufficed, adopted at the national level.

    In such an approach there would have been no place for a firm like Goldman or JPM under a gvt unbrella. These firms might own (or even operate for a fee) taxpayer-insured businesses. But their main business should be entirely unregulated and, as a consequence, uninsured to the point that any gvt action to compensate shareholders or creditors for losses would be illegal. That would reduce the scope for risk taking (and “innovation” often invented mainly to facilitate regulatory arbitrage) or require those firms to become very efficient in doing so. That would also make it far more difficult for non-regulated firms with high levels of leverage to fund themselves, because the “prime broker” function would become much more costly.

    However the main culprit is the implicit assumption that “level playing fields” for industry participants are more important than the avoidance of (a) low probability/high severity risks for the taxpayer without a matching public benefit and (b) the removal of a set of customs and practices (“commercial banking”) with a proven anti-cyclical effect in many national economies.

    It is not reasonable to expect that the “Basle” approach can be modified to preserve the level playing field plus entrepreneurial characteristics (which both might contribute to greater macroeconomic efficiency) and deal with bail-out risk and cyclicality. It has to start with old fashioned licensing of limited franchises, well supported supervision plus true privatization of risk taking outside those franchises. Just watch what happens if “bankers” can no longer free ride the public purse..

  17. No mistake. The problem is that I denounce the Basel Committee for having committed such outrageous regulatory stupidities that is it too hard for the FT, and for Simon Johnson, to believe these possible.

    Do not forget that just as my many hundreds of letters to FT on this issue have remained unpublished, my many hundreds of comment on Baseline have equally remained unanswered.

    Besides completely overhauling our bank regulations and throwing out the whole concept of capital requirements that discriminate on risk, the most important lesson to take away from all this is the immense danger of allowing a small group of self selected professionals to uncontested perform intellectually degenerative incest in a mutual admiration club… and then, seemingly with no accountability, apply their rulings globally.

    Look at the Financial Stability Board that has been created to help remedy it all but that is nothing but an exact clone of the Basel Committee’s mental framework.

    “The FSB is chaired by Mario Draghi, Governor of the Bank of Italy. Its Secretariat is located in Basel, Switzerland, and hosted by the Bank for International Settlements.”

    Does not a Mario Draghi share the responsibility of having dug the world into the hole it’s in?

    Again, if by any chance the world would confront the threat of climate change, whether real or not, with something like the Basel Committee, then we would all be toast.

  18. This is a very good comment. Indeed the stricter and better the basic capital requirements are the more important the distortions produced by the risk-weights.

    If you wanted to avoid arbitrage between countries a standard basic capital requirement to be applied by all would have done most of it, but someone wanted much more out of the Basel Committee… and so instead of arbitrage between countries we got the much worse arbitrary discrimination of bank clients based on perceived risk of default.

  19. The answer to your question is this: The banks will lend less with greater equity requirements, because they carry more of the risk if loans go sour in a financial crisis. This is so because there is more equity to lose before the government steps in.

    When the banks carry more of the risk, they have less of an appetite for the bad ones. This means that credit that has been available (e.g. sub-prime), will no longer be available.

  20. Dr L Brownstein

    Simon, your link to the NYT review is wrong.

  21. Per, “Again, if by any chance the world would confront the threat of climate change, whether real or not, with something like the Basel Committee, then we would all be toast.”

    OMG, don’t give them any more “leverage” to do that! :-)

    Fix the environmental disaster wrought by their “math”:

    More misery for others = more money for ME ME ME

    Since they’re all “austere” now, there is BILLIONS in “deficit” savings if they stopped paying out so much to carefully constructed “business model” organizations that are dedicated to burying scientific data – like for-profit health insurance companies, for instance. The DATA the insurance companies run on for generating management/shareholder profit has made it impossible to know what people really need in the way of health care and how much it would really cost to provide it.

    Ditto for “energy” sectors…

    Bottom line, the fact that there isn’t even a hint of criminal prosecutions in the air for such a massive transfer of wealth (ie THEFT) will light a fire they won’t be able to contain.

    Constitutional Convention and BURN the Patriot Act.

    And make a LIST of all the instances of INCOMPETANCE…no one has a moral obligation to be “ruled” by liars, thieves and murderers.

  22. “no one has a moral obligation to be “ruled” by liars, thieves and murderers.”

    That is true of course, but in this case I believe it suffices saying that what we must not allow is being ruled by dumb experts just because they announce themselves as experts. And it is not inappropriate or misbehaving, in any sense to speak out clearly and crudely against them, when so much is at stake and when so much misery has already been caused. Until I feel satisfied they have understood what we are talking about I will, under my own name, call the regulators of the Basel Committee stupid, stupid and stupid… and us idiots for allowing them to rule so uncontested.

    You send your kids off to wars where they might die while at the same time you allow regulator wimps to impose on your banks a total misguided risk-adverseness? Not and adverseness against the risk that banks do not perform their capital allocation role correctly and help us to create jobs for the billions of young people that need them, but an adverseness against “risk of defaults”? You’ve got to be kidding, or you do really not have a clue about what the real risks are. http://bit.ly/cUd3vL

  23. Stephen A. Boyko

    @ Rien Huizer

    That would reduce the scope for risk taking (and “innovation” often invented mainly to facilitate regulatory arbitrage) or require those firms to become very efficient in doing so. … Just watch what happens if “bankers” can no longer free ride the public purse.

    Good post. The banker’s free ride will continue via innovation so long as risky (deterministic) investments are conflated with uncertain (indeterminate) investments that have negative cash flow and are marked-to-model (e.g. NINJA MBSs). You cannot govern both determinate and indeterminate instruments with one-size-fits-all deterministic metrics.

    Dodd-Frank: A fine alphabet soup appetizer, but where’s the beef?

    http://readingthemarkets.blogspot.com/2010/07/dodd-frank-fine-alphabet-soup-appetizer.html

    Mr. Volcker is wrong! http://www.yorktownpatriot.com/article_659.shtml

  24. http://subprimeregulations.blogspot.com/2010/10/members-of-basel-committee-consider.html

    ‘In October 2010, during the annual meetings of the International Monetary Fund I publicly asked “Right now, when a bank lends money to a small business or an entrepreneur it needs to put up 5 TIMES more capital than when lending to a triple-A rated clients. When is the IMF to speak out against such odious discrimination that affects development and job creation, for no good particular reason since bank and financial crisis have never occurred because of excessive investments or lending to clients perceived as risky?”’

    That’s an important question, Per. Why don’t you send an email to Max Keiser, he might have an idea on how to challenge the Basel Committee or at least get this question out in the open?

  25. Businessmen used to BELIEVE, and often speak and act to their beliefs, that PEACE was beneficial to an economy. And that was only about 30 years ago.

    My, how times have changed. Especially when the foundation of all this slavery, thieving and murder (er, economic theory) is the POWER of fiat money to begin with? In such a scenario, of course the shamans who conjure up magic juju paper can proclaim themselves as “gods” who possess unquestionable sovereignty over their PSYCHOLOGICAL creation of an ABSOLUTE power source. And how “stupid” are they when they know that their power is ONLY held by the force of an army of bought for and paid for hooligans and degenerates with the same basic psychological make-up of greed and lust as their “massers” have?

    Their “rent seeking” is ABSOLUTE. In the USA we are paying the “massers” – inventors of business models like for-profit health insurance companies – monthly rent for having a skin suit (body). And they get to decide when and if they’ll trickle down any of your YEARS of rent to fix your plumbing, so to speak.

    We are dealing with an economic belief system that is RELIGIOUS. That’s why you cannot question the intelligence of the shaman with a common-sense definition of “stupid”.

    We are on a Spaceship that was/is/and will be trashed by the 1% of stupids.

    A lot of us have heard how they REALLY talk and think and what “math” they truly deploy. There’s only one sacred cow:

    More misery for others = more money for ME ME ME.

    And all “life” is bent to that absolute god’s will.

    You are up against a RELIGION, Per.

    Where’s the army to fix that?

  26. Annie

    Three billion young around the world unable to find jobs sounds like a mighty army.

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  28. “Many bankers oppose increased equity requirements, possibly because of a vested interest in the current systems of subsidies and compensation. But the policy goal must be a healthier banking system, rather than high returns for banks’ shareholders and managers, with taxpayers picking up losses and economies suffering the fallout.”

    Although this view seems logical, the point it misses is that, the banking system obviously is hopelessly dysfunctional and only will become increasingly so as input cost distortions caused by a global flood of liquidity pressure margins, and resolve what fascists call “excess supply” with further shutdowns of both the physical and financial economy. So, perhaps bankers oppose increased equity requirements because opportunity to increase leverage awaits an expanding cache of valuable assets brought to market for pennies on today’s dollar (this being a certainty on account of QE).

    Were it not already “too late,” would the Federal Reserve be conducting itself so?

    There is a different game on than the one the deepest thinkers believe they are addressing. If destruction of sovereign nation states were not the game’s object, then “corrective action” upholding human dignity over a massively illegitimate, fraud-riddled debt already would be underway.

  29. Shivagurunathan Ram

    While higher ownership in banks will certainly check bad loans, high cap-adequacy norms will only result in defeating the basic tenets of fundamental banking principle. Banks will cease to be a thing of its kind in the context of higher capital requirements.

    One solution is to link up overall employee compensation structure with loan portfolio (positive) and recoveries (negative) coupled with monetary penalties bearing a suitable proportion to bad loans.

  30. capitalism is not a disease

    Petter, Your answer has side-stepped the major points brought forth. From a brief discussion I had with my Professor Wang last week, on a presentation I had done, I can only disagree with equity financing of large banks. The reason is that it allows the bank to take risks that it would otherwise not have taken, due to the simple fact that risk is on the shareholder and not on the bank. Risk has been transferred to the shareholders of the equity, and decisions changes. Solomon Brother’s was the first Wall Street bank to break protocol and go public. The other big wall street players followed. The justification is to be able to complete globally with other mega-banks. To make matters worse, the “lender of last resort” system of having the Fed stand by to bail out those in need only exacerbates matters as banks that take larger risks with equity funding, can now take even larger risks with a lender of last resort (guarantor). I don’t know a lot of the various sides to this argument, only that our system failed because of inherent defects in the risk-reward structure which it has been built around. I will let you know if I can uncover more sides to the argument, because it is a hot one. Taking major wall-street banks off the public equity market would most likely solve a big problem and allow for more solid decision making built on actual models of risk and return that these banks were founded on. Casino Capitalism is alive and well in a world of equity financing and Federal Reserve bailouts.

  31. “Inside Job” is indeed a scary movie, for more reasons you might think! http://bit.ly/cK3Dc2

  32. There’s a general misunderstanding among many that equity is the same as a reserve requirement. While a larger equity layer can indeed help a financial institution weather a crisis, it does not mean that they will be any more or less prudent when making an investment decision. For an equity layer to be meaningful, the accounting has to be open and reliable, and the various debt instruments held have to be marked to market (actual trades or reasonable valuation by proxy). If the equity layer was to be held in cash or near-cash equivalents (very short term debt investments) by regulatory law, then there would be a corresponding cost on the bank as reflected in cost of capital measurement.

    A larger equity layer doesn’t really address the problems in bank risk and operations.

  33. Stephen A. Boyko

    @ Edward
    @ DDJ

    Well reasoned in both posts and consistent with my 40+ years experience as a regulator and practitioner.

    In a world of financial complexity, innovation, and bubbles, it is “randomness” that includes both uncertainty and risk that should become the main focus of robust capital market governance.

    Uncertainty is different from, rather than a higher degree of, risk. This distinction was made famous by economist Frank H. Knight in his seminal book, “Risk, Uncertainty, and Profit” (1921). Risk refers to situations in which the outcome of an event is unknown, but the decision maker knows the range of possible outcomes and the probabilities of each. Uncertainty, by contrast, characterizes situations in which the range of possible outcomes, let alone the relevant probabilities, is unknown.

    Accordingly, capital market TRTR governance dilemmas are framed by three questions.

    1. Does uncertainty exist in the capital market to a material degree?
    2. If so, can it be regulated by one-size-fits-all deterministic governance?
    3. What metric(s) demarcate risk from uncertainty in the capital market?

    These questions, in turn, engender the following responses.

    1. As there are innate complexities in the capital markets, the element of uncertainty always will be a part of complex adaptive systems.
    2. Absent randomness segmentation, indeterminate information cannot be processed effectively and efficiently by determinate metrics.
    3. The bright line that demarcates determinate from indeterminate underlying economic condition depends upon cash flow and whether marked-to-market/ model.

    The conflation of “risk” and “uncertainty” exacerbates capital market structural problems thus accelerating the troubling trend of larger and more frequent economic dislocations. It is not so much the riskiness of the structural processes related to proprietary trading, hedge fund, and/or private equity that is troublesome, but whether the instruments’ contractual randomness contained in the portfolio’s investments are of a “risky” or “uncertain” nature.

    The issue is whether it is more preferable to solve the “symptomatic problems” of scale that is “Too Big To Fail (TBTF)” and scope that is “Too Random To Regulate (TRTR)”, or whether it is preferable to fix the “market foundation” by segmenting the underlying economic condition in terms of predictable, probabilistic, or uncertain governance regimes.

  34. Nonetheless, the more equity, ceteris paribus, the more “skin in the game”. And I don’t want regulators to order banks to have different amounts of “skin in the game” depending on the ex-ante perceived default risk of their client, unless of course, the banks start charging all their clients the same risk-premium interest.