Simon Johnson asks if the Fed is afraid to regulate banks

In his Bloomberg column, Professor Simon Johnson asks if the Fed is afraid to regulate banks and if it is not afraid, why doesn't it require banks to hold a much higher level of capital.

Professor Johnson observes that

capital regulation needs to be about the true ability to absorb losses relative to total assets. Regulators should focus on this measure -- known as leverage -- and its implications for what happens when a financial company faces failure.

It is interesting that Professor Johnson says this because the adequacy of a bank's capital to absorb expected losses is the principle focus of the Fed's bank examination function.  Bank examiners ask the question of do banks have enough capital to absorb the potential losses on the risks the banks are exposed to.

If yes, then the bank examiners think the bank is adequately capitalized.

If no, then the bank examiners write up the bank and require that it raise additional capital.

Apparently, Professor Johnson doesn't think that the Fed's bank examiners are up to the task of evaluating capital adequacy.  He would like someone else to determine when a bank has enough capital.

There are two potential ways to make this determination:  the market or regulatory fiat.

Regular readers know that your humble blogger favors having the market determine if a bank is adequately capitalized.  What is necessary for the market, which includes the bank examiners, to perform this task is having banks disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

With this information, the market can use its valuation expertise to determine if each bank is adequately capitalized or not for the risks that it is taking.

With this information, the market can also exert discipline on the banks so that the banks hold enough capital to absorb their potential losses.  Recall that when banks provided ultra transparency at the beginning of last century, banks maintain a 15+% equity to total asset ratio.

Alternatively, we could have regulators write a regulation requiring banks to hold more capital.  Not only does this involve overcoming the Too Big to Fail bank lobby, but it also means the regulators publicly saying that their bank examiners are not up to the task of evaluating the adequacy of each bank's capitalization.

Ironically, in making the case for the regulators to require the banks to hold more capital, Professor Johnson actually makes the case for doing so by requiring the banks to provide transparency.

Global megabanks are profoundly complex, and intentionally so. Investors and regulators don’t know what risks are being taken. Board members also are usually in the dark. 

Whether top management understands what is happening is an open question: Chief Executive Officer Jamie Dimon is adamant that he had no real knowledge of JPMorgan’s Whale positions, which eventually had a notional value in the trillions of dollars.

Simply requiring banks to hold more capital doesn't address the fact that no one knows what risks are being taken.  Without knowing the level of risk, it is impossible to know if the regulated level of capital is adequate.

The starting point for determining capital adequacy is ultra transparency.  With disclosure comes the ability to assess the level of risk and then exert discipline to ensure there is enough capital to absorb losses.