Focus on bank capitalization leads to adoption of flawed regulatory and economic policies

Over the last several months, I have written a series of posts on bank capital.  Initially, I compared bank capital ratios to chicken soup arguing that they could not hurt.

This conclusion parallels the thinking of Walter Bagehot who observed in his classic Lombard Street that "a well-run banks needs no capital ... no amount of capital will rescue a badly run bank."

Since then my conclusion that bank capital could not hurt has changed.

As has become apparent over the last few days with the attention focused on Europe's sovereign debt and bank solvency crisis, the focus on bank capital ratios is like drinking hemlock:  deadly to the global financial system.

In Europe, policymakers and regulators are suggesting that the way to restore market confidence in the solvency of the banks is to raise the Tier 1 capital ratio for Eurozone banks from 6% to 9%.  This is a clear indication that the financial regulators believe that market participants think that capital ratios are an indicator of solvency.

Unfortunately, they (and a handful of economists) are the only market participants who believe that capital ratios are an indicator of solvency.

Every other market participant knows that bank solvency is a function of whether the market value of the bank's assets exceeds the book value of the bank's liabilities.  Even Wall Street's bank analysts agree with this calculation as the way to determine if a bank is solvent or not.

The financial regulators' focus on capital ratios leads directly to the adoption of flawed regulatory and economic policies. 

Here are three examples.

First, the focus on bank capital ratios acts as a barrier to banks recognizing the losses on their assets during times of financial instability.  Since financial regulators have equated high capital ratios with solvency, they are reluctant to require banks to recognize the losses on their assets as doing so reduces the banks' capital ratios and presumably tells the market the banks are insolvent.

Adam Levitin wrote an interesting post that discusses the impact of regulators not requiring banks to recognize their losses on mortgages and its implications for economic policy:

It’s time that we recognize that negative equity is the critical problem in the US economy. Fix negative equity and you will fix the US economy. That is because negative equity is the key for repairing household balance sheets, and that is the catalyst for getting consumers spending again, getting banks lending again, and getting businesses hiring again. If we’re serious about dealing with negative equity, we need to address it directly and not engage in an extend and pretend dance. 

It’s also time that we recognize that negative equity didn’t just appear by itself. This wasn’t a freak weather event. It was a man-made disaster. We ended up with negative equity because of a housing bubble inflated by very deliberate acts by a limited number of financial institutions that profitted greatly from bloating the economy with cheap and unsustainable mortgage financing. We witnessed a macro-economic crime and are living with the consequences of it… 

There’s only one way to skin this cat. The negative equity has to be eliminated. Period. We hoped at first that we’d grow out of it. Fat chance. This is the anchor weighing down the ship. So now it’s just a question of whether we try to clear the market via foreclosure or whether someone pays to clear the market, meaning that the book values at which mortgages are carried are written down to market values or something close to it.

Second, the focus on high capital ratios does not accurately identify which banks are solvent and which are not.  At the same time, the financial regulators reliance on this measure creates the moral responsibility to bailout bank investors.

Since 2009, global financial regulators have run stress tests under which all banks with a high capital ratio received a passing grade.  This included banks, like Dexia, that needed to be nationalized less than 3 months after receiving a passing grade.

There is a moral responsibility to bailout an investor in a bank that the government has just said is solvent.

Third, the focus on high capital ratios blinds the financial regulators to the fact that requiring banks to disclose their current asset and liability-level data would make it easier to supervise the banks and eliminates the moral responsibility to bailout bank investors.

With access to this data, market discipline becomes possible.

Market participants have an incentive to analyze this data as they know that they are responsible for any gains or losses on their investment exposures to the banks.  Naturally, as banks increase their risk, market participants are going to push back by increasing the bank's cost of and lowering the bank's access to funds to reflect this change in risk.

In addition, regulators can piggyback on top of the market's analytical capabilities.

Finally, requiring banks to disclose their current detailed asset, liability and off-balance sheet exposures eliminates the need for many of the regulations that have been proposed or developed since the beginning of the credit crisis.