Wednesday, January 5, 2011

The Problem With Regulators' Fixation On Capital

Courtesy of the American Banker, we discover that the regulators' fixation on bank capital can produce blind spots.
Will Regulators' Fixation on Capital Produce Blind Spots?
Policymakers are obsessed with capital, and it's easy to understand why. It is central to confidence in the banking system. It is quantifiable. It's tangible.

Actually, in our current banking system, capital is none of these.

Lehman Brothers had capital in excess of 10% of its assets when it filed for bankruptcy.  So much for central to confidence.

Given the ease with which it can be manipulated, it is not clear that the quantity of capital shown on a financial institution's balance sheet means anything.  When the credit crisis hit, regulators made sure to have mark-to-market accounting suspended so that a larger capital number could be shown.  In addition, regulators have shown a comfort with zombie loans being extended indefinitely and, since the bank pretends they are performing, overstating capital.  Just ask the Japanese about this practice.

Tangible suggest that it can actually be used to do something like absorb losses.  However, regulators do not appear to be keen on making it perform this function otherwise we would not be faced with the problem of Too Big To Fail.

Those are all good things, and everyone agrees a solid banking system is founded on a sound capital base.
Actually, a solid banking system is founded on asset-level disclosure.  When credit market analysts can value all the assets, then and only then, do we know if a bank is solvent.
But the focus on capital may be creating a false sense of security, and it may be overshadowing other, equally important issues that are central to preventing the next crisis, like how well banks are managed and how well supervisors do their jobs.
As regular readers of this blog know, the regulators' fixation on capital is one of many blind spots.  These blind spots prevent them from taking the necessary steps to restore a solvent banking system and perpetuates the current financial crisis.

Your humble blogger absolutely agrees with the American Banker's observation that the focus on capital overshadows issues that are central to preventing the next crisis.  The issue that is overshadowed is the disclosure of asset-level data.

With asset-level data, the credit market analysts working for investors and other financial institutions would be able to assist the supervisors/regulators in doing their job.  For example, they would alert the regulators if a bank were not well managed or were taking on risks that threaten the solvency of the bank by exerting market discipline - sell ratings, reductions in lines of credit, etc....

This is precisely the banking environment that everyone wants as it produces a stronger banking system.

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