Capital requirements smackdown watch

Eric Falkenstein writes:

How much capital for derivatives? Good question. Should it be weighted by risk? If so, how does one measure risk? Considering that risk is a function of the collateral, which comes in many different flavors (traded debt, pools of mortgages, pools of bank lines), and then are structured very differently, with differing levels of subordination, differing rules for the waterfalls of cashflows depending on various metrics of collateral quality. It’s a mess.

…You may think this is no different than regular lending, but you would be wrong. For example, lets say you have two swaps, but they both offset each other almost exactly for interest rate risk, but as they have different counterparties, they have differing credit risk. How about swaps from the same counterparty, but differing interest rate exposures, partially netted. How much should capital be netted? And if the US banks have capital requirements greater than economically necessary, how many seconds before all swaps would move offshore?

I take him to be saying that financial institutions can never be transparent in their risk-taking, or at least not in the sense that can be made accountable to a regulator.  Read the whole thing.  Read also Doug Colkitt’s comment here.  Note by the way that Bear Stearns, at the time of its collapse, had met Basel capital requirements.

Mark Thoma writes:

I’d argue that even though Basel was not perfect it was much better than having no regulation at all…If the regulations under Basel caused banks to move assets off the books, then without regulation they wouldn’t have needed to move them, but the assets still could have been used in the same way, financial institutions could have taken the same risks and would have had the same or more incentive to do so without regulatory oversight, and they could have caused the same troubles. I don’t see how the regulations themselves caused the risk taking. Regulation caused evasion of regulation, and Basel II is trying to deal with that problem, but the regulations did not cause the risk-taking itself.

Currently my view is closer to Thoma’s.  The case against regulation requires that derivatives risk is observable (by the bank itself, and of course if it is not observable to anyone run the other way!) but not verifiable to an outside regulator (otherwise it could be controlled by regulation).  Even in that case, however, more informal systems of regulation should work, albeit imperfectly.  Yes banks will sometimes lie and trick the regulators but at least another layer of protection is in place.

There’s lot of talk about the government buying up mortagages.  Even if you favor that plan, it’s a one-off measure, not a long-term solution to stop a future crisis.  There is in fact a paucity of good regulatory proposals on the table.  There are plenty of ideas for how to stop what went wrong "last time" but fewer good ideas for how to stop the next version of a financial crisis.


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