Thursday, March 4, 2010

Capital Is The Fool's Gold Of Banking

Is capital important for the health and safety of the banking industry? Was a shortage of capital the reason there was a financial crisis and would higher capital levels prevent another crisis? Wasn't liquidity the real cause of the recent banking problems?

One of the proposed solutions to prevent another banking industry crisis is to require banks to hold more capital. However, the banks that needed bailing out or failed in the recent crisis all satisfied the existing capital requirements. Capital is just a naive and confused patent medicine approach to a complex problem.

Bear Stearns and Lehman failed because they had a liquidity crunch and Citibank needed government help because it was experiencing a run on the bank, a liquidity shortfall.

Capital is a balance sheet approach to bank supervision and control. It is a regulatory concept computed by a regulatory formula. It does not represent the residual liquidation value of the bank after its debts are paid. It does not represent the bank's net worth, the accounting or market value of the banks assets less it liabilities. It does not represent the future earnings capacity of the financial institution. It does not measure the liquidity health of a financial institution.

Regulators establish guidelines for bank capital levels and monitor the capital levels of banks. Governments, and their agencies, such as the banking industry regulators, cannot act arbitrarily. Capital levels are the way that the government banking regulators justify their actions. When capital levels are threatened or below regulatory requirements, federal banking supervisors act to preserve deposits, and the deposit insurance fund. They close banks, merge unhealthy banks with healthy banks, or put banks under protective orders with restrictive requirements. They act with a consistent, predefined purpose and as such are not easily subject to judicial review to overturn the regulators' actions and interventions. Capital levels are just trigger points that allow the government to act in a consistent manner.

Suggested proposals to prevent another crisis are mere refinements to the current capital requirements. The arguments for change are that the risk adjustments were inadequate, incentives were wrong; the levels were too low, or inconsistent, etc. However, any set of capital rules will not cover all situations, will create a new set of economic incentives and will always be too low for some catastrophe, just as a dike cannot restrain all levels of water.

Often a banking crisis is a liquidity crisis. Customers notice bank problems when banks are having a liquidity problem, a run on a bank, because the bank does not have the funds to pay depositors' withdrawals or the funds to make loans.

Regulators like high capital amounts because it allows them to delay classifying a bank as a troubled bank and delay government intervention. It does not guarantee an improvement in the deposit insurance fund or a positive net worth at a bank. It does not measure or help a bank's liquidity needs.

Capital does nothing to prevent liquidity problems at banks. When a bank is experiencing a shortfall of funds, the institution must borrow funds to pay depositors, and fund new loans and meet daily cash needs. To borrow funds, a bank must often put up collateral, assets it has on its books. Usually, the liquidity lender to a bank wants the collateral amount, in market value, to exceed the amount of funds lent. Bear Stearns failed because as it needed more liquidity, the value of its collateral was decreasing due to the declining value of real estate and the increasing default rates on mortgage loans. Some of its mortgage backed securities it was using as collateral declined in value by as much as 70 percent. Eventually, Bear ran out of collateral and could not fund it daily operational needs.

Capital is nice to talk about because the regulators find it easy to measure, not subject to dispute or interpretation under the regulations and consistently applied to all banks. It is easy to explain when a bank is above or below required capital levels and requires government involvement.

Liquidity is a much more difficult concept to use because the liquidity needs of each bank are different and can vary within an individual bank over a short time. It is more difficult to monitor, more difficult for the public to see when a bank is short of funds and more difficult to explain to politicians and the general press. Furthermore, publicly disclosing a liquidity shortfall at one bank can create a panic and run on another bank. Using liquidity as a guideline for bank troubles can cause a broader financial problem and make it much more difficult for regulators to contain a problem to a sole bank.

The contagion in the recent crisis was, in effect, a run on the banks. Everyone feared that the financial institutions were running out of liquid assets and that the collateral was declining in value in excess of the liquidity needs of the institutions. There was a wide spread fear that the banks did not have enough cash for their daily operational needs.

Capital is easy to understand and for regulators to measure. It is a convenient and acceptable trigger for regulatory intervention. Capital, however, does little to minimize future banking problems. It does nothing to promote the best practices for preventing future banking crises. Capital does not promote good banking, which must include asset diversification, sound business strategies and decisions, quality management, expense control and strong, sustainable earnings.

Reform, instead of focusing on capital levels, should instead focus on promoting sound banking practices as previously mentioned. Best business practices are the best way to prevent another crisis. Raising capital requirements by itself does not promote best practices. It just makes the regulators feels happy and allows them to offer patent medicine to those in search of a tonic.

Capital is a fool's gold that has little value, if any, in a severe financial crisis. The real gold is asset diversification, sound business strategies and decisions, quality management, expense control and strong, sustainable earnings.

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