Thursday, May 3, 2012

Blinded by dogma, regulators needlessly protect banks

Ultimately, the choice between protecting the real economy or bank book capital levels reflects the degree to which financial regulators and policymakers are blinded by the dogma that maintaining positive book capital is a necessary condition to prevent a run on the banking system.

If the current financial crisis has shown anything, it has shown that this is not true.

Examples of banks with positive book capital that have sustained runs on their deposits abound across Europe.  Just look at what has happened to banks in Ireland, Greece, Portugal, Spain and the Netherlands.  After the last two rounds of stress tests in the EU, three of the banks identified as having the most capital had to be nationalized.

Clearly, there is something going on that drives bank runs that positive book capital levels do not address.

Your humble blogger would like to suggest that what is going on is that market participants are not stupid.

They know when a real estate bubble bursts and prices decline by 30 - 70% that the banks are likely to be holding assets that have declined in value by more than a bank's book capital level.  This is common sense.

The question that market participants face is do you take your money out of a bank that has had its book capital wiped-out?

Market participants have answered this question by looking at the strength of the sovereign guaranteeing the deposits.  This is common sense.

Where the sovereign is in a precarious position, examples being Ireland, Greece and Spain, then market participants withdraw their money and deposit it elsewhere (like Switzerland or Germany).  Where the sovereign is not in a precarious position, the market participants are keeping their money in the bank.

Market participants are also not fooled by financial regulators' efforts like the 9% Tier I capital ratio target.

They know that bank book capital is meaningless (at a minimum, the OECD confirmed this).  Market participants know bank book capital is meaningless because of policies like suspension of mark-to-market accounting and regulatory forbearance.  These policies prevent existing losses on and off the bank balance sheet from reducing bank book capital .

Given that market participants base their decision on whether to keep deposits in a bank on the strength of the sovereign guarantor and that they see bank book capital as meaningless, why then do financial regulators and economists keep focusing on it?

Because of the dogmatic belief that it is important.

A dogmatic belief that is as wrong as the dogmatic belief that markets are self regulating.

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