Friday, June 10, 2011

Regulators Need to Stop Obsessing Over Bank Capital Amounts

From Bloomberg, "Fed Said to Consider Expansion of Capital Reviews" by Craig Torres:
The possible expansion of the reviews shows how the Fed and other regulators are focusing on capital as the most important buffer against risk.
Capital is an ancient artifact of double entry bookkeeping that has little use to protect banks in today's modern financial world. It is an balancing account so that the liability side of the balance sheet will match the asset side of the balance sheet. More capital, shy of 100 percent, would not have prevented the last financial crisis.

The bank crisis was initially a liquidity and funding crisis, which no amount of bank capital, shy of 100 percent, could have prevented. Lehman and Bear Stearns ran out of collateral for funding due to the decreasing collateral value of mortgage related securities. Citibank and other banks faced similar short-term funding and deposit withdrawal crises.

When a financial institution borrows, it always faces the risk that a rollover refunding and refinancing crisis will occur. Bank capital does not alleviate that risk, since capital reflects neither liquidation value, stock market value, selling price value, going concern value nor liquid securities or cash on hand.

Capital is an easy accounting metric to tally and to periodically report to regulators. More capital does not prevent financial crises. It however is an established regulatory metric and trigger for a regulatory takeover of an institution. More capital in a crises just delays regulatory involvement but it does not prevent financial institutional crises.

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