Does bank capital prevent crises?

Òscar Jordà, Björn Richter, Moritz Schularick, and Alan M. Taylor have a new and somewhat unsettling NBER paper on that topic:

Higher capital ratios are unlikely to prevent a financial crisis. This is empirically true both for the entire history of advanced economies between 1870 and 2013 and for the post-WW2 period, and holds both within and between countries. We reach this startling conclusion using newly collected data on the liability side of banks’ balance sheets in 17 countries. A solvency indicator, the capital ratio has no value as a crisis predictor; but we find that liquidity indicators such as the loan-to-deposit ratio and the share of non-deposit funding do signal financial fragility, although they add little predictive power relative to that of credit growth on the asset side of the balance sheet. However, higher capital buffers have social benefits in terms of macro-stability: recoveries from financial crisis recessions are much quicker with higher bank capital.

Here is Christopher Balding on whether China is deleveraging.


Preventing crises is probably not possible or even optima in the long term. The recovery speed and whether the downsides are contained primarily to the appropriate parties is more important.

If you make banks 10% safer they will take 10% bigger risks.

"Contained to the appropriate parties" is a big one. Lots of people, not just the bankers, want to try to socialize their losses, and if they get enough people to go in on their craze, they will have a good group to lobby for relief. See: housing bubble.

I don't know if there is any way to get back to having the investment banks be limited partnerships, but then the principals knew that it was their retirement on the line if everything blew up.

> Lots of people, not just the bankers, want to try to socialize their losses, and if they get enough people to go in on their craze, they will have a good group to lobby for relief. See: housing bubble.

What exactly was the risk that was socialized with the housing bubble? The banks realized massive losses. The government made a significant profit on TARP. Approximately 100% of the losses related to securitized mortgages were realized by banks or private investors.

Only the stupid banks lost money on securitized debt. They were stupid for holding debt when the music stopped.

One bank sold off all the debt before the crash and suffered losses only due to paying billions to settle civil suits arguing they committed fraud. Which they would have won eventually at SCOTUS with Scalia, Roberts, Aliso,... but the risk was a SCOTUS created by Clinton.

The shadow bank that started the 2007 crisis for real lost its investors who thought they were bank depositors about 1% and their "cash" frozen for weeks. Primary Reserve Fund. I'm old enough to remember when "liberals" predicted 2007 in 1970, and Milton Friedman said 2007 could never happen.

The bank bailout that happened was "unconstitutional lawless big government overreach" - the Fed and FDIC retroactively insuring all shadow bank deposits as if they were BofA or Citi checking or savings deposits. October 2007, long before TARP v2007, but 17 years after the expired 1990 TARP.

The music that stopped was "Capital always gains value, capital always goes up in value, capital always gains".

And by that time, a bond based on a bond based on real estate rental income was considered capital.

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"Preventing crises is probably not possible or even optima in the long term"

From 1935, Regulation Q prevented crisis until mid-70s to mid-80s. Since there have been at least three crisis in the US with one headed off by "capital" strong armed into preventing panic.

Was 1935-1975 worse without crisis than 1975-2015 with multiple crisis, just in the US. The destruction of Regulation Q was global, with Germany being the biggest holdout.

Note "Regulation Q" is a label proxy of core ideas like "liberal" that was turned into an evil to be eradicated. As it does not have the power today, it can't be blamed for the inability of people who can't service debt being able to borrow. Instead it's blamed on Dodd-Frank and Obama.

No matter how much capital, the people getting rewarded to lend more money are gambling with other people's money, unless they are the capitalists who lose all their assets before bad debts start redistributing the wealth of savings depositors to the borrowers borrowing to consume, ie, the home owners refi'ing the house they bought 15 years ago to pay off debt from going shopping and on vacation with 35% debt.

In the early 70s, I was saving 40% of my income, was getting large annual wages, but at 24 with 3+ years in my job and $3000 in savings, I was too risky for Amex to sell me a charge card for $35 annual fee. Bank credit cards did not exist generally because of Regulation Q capping personal unsecured debt at 12% in Indiana. And Amex did not issue credit cards until circa 1990, 100% payment was due on presentation of statement. All retailers issued credit at 12% but they allowed only small purchases except for assets their repo man could take back by coming to your house and taking your washer or frig or living room set or TV or car. Sears never let you use your Sears credit card to shop at Wards or Macy's.

To travel, I had to deposit my cash with Amex who gave me internationally known bearer bonds. Or carry $20s. Ideally both because Amex $20 bearer bonds were converted at a steep discount to $20 bills. The Amex bearer bonds were insured against loss.

Was this inconvenient for me? Yes. Was it frustrating to me? Yes. Did I jump through hoops to become worthy? Yes. Did I borrow $1200 to buy a car through the car dealer using the $3000 in savings plus the $2200 car as collateral to get a credit history? Yes. Did I qualify for an Amex card or bank card? No. At least not until I started working for a global corporation as they required me to get an Amex card they secured.

What I learned growing up under Regulation Q is that if I wanted the American Dream I had to work AND SAVE and pay a lot of cash for it before any lender would consider lending me a dime, unless I was going to be owned by my lender who would control my life, whether the loan sharks or Sears, Wards, the car dealer.

In the 90s, I was shocked to learn many of my younger peers earning the same as I were deep in debt, doing their 2nd or 3rd refi to pay off tens of thousands in 35% interest debt. Meanwhile I was saving $30,000 a year plus rapidly paying off my mortgage I kick my self for taking out instead of selling stock and "losing out on the capital gains". At least thankful I did not buy a $400,000 house like everyone told me I should in 1986. After all, getting rid of Regulation Q was "creating wealth" by letting everyone, especially workers become highly leveraged with debt they could not service because ASSETS ALWAYS INCREASE IN VALUE, so you do not need income to pay off the debt. Growing up in the 50s and 60s, I knew that to be a total lie, so I bought a house for $200,000 knowing the value was no more than $170,000, but surprised when the price fell to less than $140,000 within two years. And the stocks I owned fell by the largest percentage since the 29 crash. The years: 1986 to 1988. Reagan's economists blocked fixing things, so it was Bush who had to bailout the banks with a massive TARP bailout bill in 1990. My house reached $200,000 as a nominal price in 1995, and reached the inflation adjusted $200,000 in 2000. Today, my house is back to inflation adjusted $200,000 after 30 years, having gone slightly above, and below, and now back up to parity.

Regulation Q required banks to operate in reality where assets do not increase in value but constantly depreciate. Eliminating Regulation Q was based on free lunch economics of inflating asset prices signaling increased asset value. Ie, after 10 years, your car is at least 50% more valuable because it now has 150,000 more miles in life in it than when you bought it, and your house can handle twice as many people living in it.

That is not what Regulation Q did at all.

Where do you get this crap?

Stopping the previous crisis is easy.

Stopping the next crisis is hard.

Often whatever structure was put in place to stop the previous crisis is used as a secure foundation by risk-takers to cause the next crisis.

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So it's a sort of "Get well soon" insurance.

By the standards of governments, central banks, and so on, that's quite a good result.

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SCOOP: Asset quality is important.

Which is another way of saying that disciplined credit control is.

Amusingly the article never even references this let alone explores it.

Contra to Barclay's 'may the devil take the hindmost' comment, this just underlines the importance of bank regulation & regulators-to police lending standards & asset quality - so that systemic emergencies never emerge, let alone occur.

Doubtless that the ink stained wretches authoring this paper never worked in a bank.

Moritz Schularick: now that's a stage name.

Proyally never heard "Regulation Q".

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Why is it unsettling? It looks like car insurance. Being insured does not prevent accidents, but it helps to recover after an accident.

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Anything less than a 100% capital reserve ratio risks a financial crisis, but at the cost of economic growth (or at least that's the assumption). But the more important issue than the risk of financial crisis (like the poor, we will always have financial crises because investors underestimate risk) is the recovery. While one martini may result in a slight hangover, five will result in the plague. Whatever risk bank banks may cause, this list will give one pause about what's considered a sound investment strategy:

Good regulators do not underestimate risk.

Utility regulators in the 70s never underestimated the risks of the nuclear power plants from a financial standpoint or legal standpoint. What they could not anticipate was Milton Friedman winning his argument on utility regulation and his views becoming law. Ultimately, Friedman lost at SCOTUS when "deregulation" was deemed a "taking" and utilities won compensation from taxpayers who taxed customers with a tax called "stranded costs". Of course, Friedman was simply gambling with other people's money when he laid out how utilities should treated under the law. But in the interim, the free lunch promised by Friedman led to PURPA and State laws which caused a financial crisis for utilities that "destroyed wealth" forcing bankruptcy, etc.

Both the right and left loved the free lunch promises of Milton Friedman: cheaper electricity by not paying to build nuclear power plants and higher profits.

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Capital requirements make banks buy sovereign debt. I'm sure if that's intentional or not, but it's what is happening.

The supply of US government debt is increasing much faster than productive land, productive factories, productive real estate.

All three of the latter have been falling in the US. Consider Appalachia: how much land as increased in productivity after mined for coal by blowing up mountains and filling valleys. Or turns the underground to Swiss cheese so the surface land grows sink holes. Or the flyover country where factories are closed and farming reduced to producing input to manufacturing machines using the least labor possible instead of producing food people actually eat in a form connected to farms. What is the productive value of the thousands of small abandoned towns in flyover ciuntry?

I find it absurd when conservatives blame liberals for housing being too expensive. I bet I could locate a million cheap houses that are cheap because of policies conservatives have pushed. BTW, This Old House is featuring one of the really cheap houses: a house in Detroit, cheap because conservatives define a house owned by black people as worthless and a spreading decay, because a black earning $50,000 is worth less than a white earning $40,000.

But debt from tax cut welfare for white people is extremely valuable and stable.

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Basel III guidelines on risk capital weighting 'make banks buy sovereign debt'.

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Averting emergencies is likely unrealistic or even optima in the long haul. The recuperation speed and whether the drawbacks are contained principally to the fitting gatherings is more vital.

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Does bank capital reduce the likelihood that your checking account and savings account will be stolen by the bank or does it reduce the likelihood of a government bailout to protect the accounts.

No and no.

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A "yes" answer would be uncomfortable for those who prefer to think that things work best when there are no rules.

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The "first line of defense" against losses/insolvency are operating revenues. Asset quality, minimizing loan charge-offs, is also vital.

The Purposes of Bank Capital - Absorbs losses (cash flows from revenues is the first absorber of losses); promotes public confidence, restricts excessive asset growth (a check on management risk-taking), and provides protection to depositors and the FDIC insurance funds.

In bank examinations, the rating areas are CAMELS: Capital, Asset Quality, Management, Earnings, Liquidity and Sensitivity. Then, a composite is assigned. It's more art than science, the composite rating is not a numerical average of component ratings. Bank examinations are subject to multiple levels of review before issued and enforcement actions commenced.

Management is the most important rating area. The other rating components are measures of management's effectiveness, efficiency, and risk appetite/profile.

Going bank to bank capital, the quality of capital is as important as the balance. It needs to be absolutely permanent (no maturity or div/yield adjustment for any reason) and 100% available to absorb losses.

Before the S&L Crisis blew up in 1989, for nearly a decade (in response to Volcker's high interest rate environment which drove many S&L's into earnings insolvency: interest expenses greater than interest income - 30 year mortgages short term deposits) the FHLBB (S&L regulator which no longer exists) had allowed creative (contributed nonfinancial assets of questionable FV, etc.) capital maintenance, added commercial real estate lending authority, allowed untoward asset growth, and permitted accounting inventions (deferred loss accounting) were codified and allowed for material, unnatural asset growth which increased the ultimate resolution costs to US taxpayers.

Capital is usually divided into multiple classes for risk assessments. In addition to reasons more related to the direction you're going with it, it's also useful to be able to separate between interest rate risk, market risk relating to equity markets, and some handful of other typical categorizations.

"separate between interest rate risk, market risk relating to equity markets, and some handful of other typical categorizations." The S CAMELS component is intended to address such risks. FDIC-insured banks should have very minimal exposures to equity markets.

Asset and off-balance sheet items risk weightings are also important in assessing/measuring capital adequacy. The recent Basel III, risk-based capital changes are very complex. Sadly, politicians involved themselves in finalizing mortgage loan risk weights. The original proposal called for home loan risk weights as high as 200%, for nontraditional, poorly underwritten types - the loans that were packaged and caused the 2008 debacle. That was shot down, and no home loan has a risk weight greater than 50%. So it goes.

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"in response to Volcker’s high interest rate environment which drove many S&L’s into earnings insolvency"

False. It was the erosion and killing of Regulation Q.

In the Volcker era we had the erosion of Regulation Q with "disintermediation". Ie, cash flowed out of regulated banks into unregulated shadow banks. The banks and S&Ls should have cut lending faster. But when they did, they lost revenue to the increasingly unregulated mortgage originators and mortgage buyers. Which unfortunately ended up being some banks and S&Ls where their State charters allowed them to.

Volcker never changed the rate of growth in the money supply by enough to justify the high interest rates. He did increase the capital requirements in 1979, which was quickly reversed, but the bidding for loans triggered rate increases in the commercial market creating demand for deposits of shadow banks which were not handcuffed by Regulation Q. Thus banks and especially S&Ls hemoraged cash as money flowed from insured deposits to money market funds, like Primary Reserve Fund. Remember, Primary Reserve Fund would NEVER make risky loans, like to Bears Stern. Milton Friedman promised in 1970....

Volcker figured out disintermediation was making all measures of money change meaning from the mid-70s though 80s, after the fact. But it's not clear what actions the Fed would take to offset the changing bank laws changing the behavior of savers. How could the Fed replace the cash savers took out of banks and S&Ls and put in money market funds?

Do you have any idea how the Fed could give money to State banks and S&Ls which were not Fed bank members to offset their cash outflows?

The S&L's were expendable.

We know Volcker didn't factor in the effects on S&L's of the Fed raising market interest rates, say, 1,500 basis points.

To end inflation, Volcker/Fed ran rates up. PERIOD. He/they did not care about the effects (MASSIVE OPERATING LOSSES, negative net interest margins, disintermediation) on S&L's.

The S&L's (it was the raison d'etre) were loaded with 30-year fixed rate mortgages at 6% to 6.5%, or lower, funded with relatively short term deposits at average 3% interest expenses cost. The prime rate went to 21%. The six-month T Note was over 14%. MMF's paid approximately those yields: in those days they prudently invested in ST, high quality debt instruments wit a small fee.

S&L's would have needed to keep the overall interest expense at 3% to 3.5% of average assets to cover interest expenses, overhead, reserve for losses and accrete surplus/capital in a mutual form corporation.

If Reg Q had not been eased and S&L's had not been able to pay higher interest rates on the deposits, then so much more of the deposits would have run to MMF's that the S&L industry would have collapsed at huge costs to the FSLIC, and the taxpayer.

Academics have not a clue. Capital is "cool" except that banks need financial leverage to earn adequate returns on equity capital (ROE). Older people in banking used to quip, "FDIC means 'forever demanding increased capital.'"

"Do you have any idea how the Fed could give money to State banks and S&Ls which were not Fed bank members to offset their cash outflows?" They couldn't in 1980. They could in 2008, and then again from 2009 to 2012 in the forms of bailouts of various brokerage houses, and $4 trillion in QE asset purchases from the big banks and Wall Street firms that they forced, in October 2008, to become BHC's with TARP laws.

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Echoing some of the comments above, it was always my impression that capital was there to absorb (larger than expected) losses in the event of a crisis. It's not there to prevent the crisis itself. It may be intended to prevent an already-underway crisis from worsening (the institution can, in theory, absorb the losses and keep operating, rather than close its doors) but I don't think it's expected to prevent the crisis altogether.

Higher capital ratios --> less severe crises and fewer bailouts.

Most especially to prevent a run on the bank.

Crisis hits and will wipe out 10% of assets.

At a reserve ratio of 15%, you're OK.

At a reserve ratio of 5%, every branch will have lineups to take out cash, and you'll be out of assets before you even have time to realize the losses. End of bank.

High yield, high risk. Caveat emptor.

Google FDIC deposit insurance. During the recent (it will not be the last) crisis there were few bank, depositor runs. There were runs of uninsured, hot money, noncore, volatile funds which proper managements either limit or avoid. A financial analysis of failed banks since 2008, would reveal along with huge asset defaults, an over-dependence on non-core, volatile funding, to the tune of 30% of total funding.

The current "immigration" hysteria generally refuses to acknowledge the existence of legal and illegal immigration. Similarly, in 2008 the Fed and gov elites treated investment banks, mortgage originators, and other wildcat "banking" schemes as if their creditors merited the same protections (which banks pay for with FDIC assessments/premiums) as insured depositors in FDIC-insured banks.

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"A solvency indicator, the capital ratio has no value as a crisis predictor"

BUT how was the value of the bank's capital assets in that ratio calculated? Weren't there many banks that held capital assets with a market value far below what the banks were allowed to claim when reporting their capital ratios? Such as, CDOs that were vastly over-valued, and residential mortgages whose value had not been fully adjusted to account for reasonable risk premiums as well as current, higher interest rates?

If so, perhaps the problem truly was more insolvency than illiquidity? How can one draw good conclusions from bad data?

Most likely according to Basel III specifications.

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If the CDO sold for $1,000,000 it was valued at $1,000,000 and thus could never be overvalued according to free lunch economics.

You must be a TANSTAAFL economist if you thing the value can be different than the sales price, and think the labor cost to create an asset sets an absolute upper bound on value. In which case you must be a supporter of "Regulation Q" which was eliminated by free lunch economists in the 70s and 80s to create higher growth and wealth.

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I just discovered "Marginal Revolution." I think it's terrific. What took me so long?

Bank capital issues are a bit of an obsession of mine. Here's something that everyone has unaccountably missed: bank capital standards (Basel I and II) caused the 2008 financial crisis. In a nutshell, these regulations drove European banks and US shadow banks to become egregiously over leveraged and stoked insatiable demand for assets that Basel classified as "low risk". Assets such as sub prime MBS and Greek sovereign debt (oops.) Thus, the crisis was really the mother of all unintended consequences. Moreover, the great untold secret of the crisis was the strength of the US commercial banks, which carried twice the capital of their European competitors. These issues are addressed in excruciating detail in my post "Basel: Faulty" on my blog, along with several other banking-related rants.

If I am right, then all the regulatory efforts we have undertaken since the crisis have been profoundly misguided. If I'm wrong, I'd like someone to tell me why.

This is probably not the space to provide a full critique of your blog on "Basel Faulty" and there is no comment section on your blog. I'll only offer a few points. Fannie Mae and Freddie Mac were only incidental players in the financial crises and certainly never rose to the same level as the shadow banks. WaMu was not a shadow bank like Countrywide. Wachovia (which was my bank until the Wells Fargo take over in 2008) had a horrible balance sheet and were one of the greatest abusers of NINJA loans. They were doomed to failure in spite of their capital (I know this full well as I poured over their 10(k)s in the early aughts wondering if it was a good investment; it wasn't. You really should have spent more time on the impact of the all the investment banks that were creating "assets" out of thin air as well as the companies that got nailed for insuring these. The MBSs, CDOs coupled with lax lending standards by all parties led to the real estate bubble that when punctured led to a financial disaster that we are still digging out of. As Michael Lewis so skillfully documented in "The Big Short" there were some savvy investors who recognized this early on and made a tidy profit.

The Euro banks were not only involved here in the US but also in some Euro countries such as Spain where there was a huge building expansion that has crippled that country.

The building boom in Spain created an economic boom in Spain. The problem is the real estate was sold to foreigners borrowing far more than they could afford from Spanish banks, secured by reasonable capital, the real estate plus down payments, for vacation and retirement housing, plus real estate developments to support them, like shopping centers. When these foreigners could no longer afford to pay for their homes, the Spanish did not need what they were producing for export, or what they had built for export which was not paid for. Spain was exporting homes.

Spain was faced with the same problem China has. China has boomed building stuff they sell to foreigners, but if the foreigners can no longer afford to pay for the stuff, the China economy will face a financial crisis with asset prices crashing, debt defaults, etc, just like Spain.

The difference is China is too big to fail while Spain is only big enough to take down a few global corporations, except letting Spain do that would trigger letting a dozen other nations to fail taking down a few more global corporations each.

Trump wants to "fail" China which has over invested in exports far more than Spain as a share of gdp. But that would "fail" Apple, Walmart, GM, Honda, Caterpillar, eg, 20% of the Fortune 500.

The global recession hit Spain's export hard: real estate aka tourism. Biggest importers are UK, France, Germany.

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Dear AlanG,

First of all, many thanks for looking at my post and for your thoughtful, informed reply. I am convinced that the Financial Crisis could never have happened absent the Basel Regs that permitted (incentivized) European banks and shadow banks to become as over leveraged and illiquid as they ultimately became. Remember too that Basel II allowed banks to value derivatives pretty much however they chose. But I suspect that there are other important factors that I may be missing or underestimating. Thanks for pointing some of these out. I'll try to respond.

1. First, I confess to being virtually a tech illiterate. I've tried to figure out how to allow responses on my blog, without success. I'll try again. Sorry.

2. Some folks I think, exaggerate the culpability of Fannie and Freddie in the crisis (e.g. Peter Wallison). That said, I think F&F (and other US housing policies were absolutely critical in creating a market for subprime loans that enabled Countrywide, New Century, et al, to do their worst. According to Wallison, Fannie's loan purchases with LTV's exceeding 95% jumped from 4% in 1999 to 26% in 2007. It is difficult for me to imagine the sub prime mess becoming as big as it was with F&F leading the way.

3. One of my key arguments is that US commercial banks -- those regulated by the Fed, FDIC and/or OCC -- weathered the storm amazingly well relative to European banks and shadow banks. In my view, WAMU was certainly a shadow bank. Regulated by the OTS, they were pretty much allowed to do whatever they wanted. You may have known Kerry Killinger, WAMU's CEO. It's a wonder he was considered employable in any capacity, let alone as CEO.

4. I have always believed that Wachovia's problems stemmed mostly from their Golden State deal. I'll check this. Thanks.

5. Investment Banks were clearly, in retrospect, concocting assets out of, well, nothing (or worse.) But remember, they were churning it out because there was huge demand for all that crap. Where did this demand come from? I believe the demand was from institutions who wanted to buy assets with a 20% risk weighting and get 5 times the leverage they could with loans, and write all kinds of derivatives in the bargain. Basel allowed them to do that. Remember too that Moody's and S&P rated much of this stuff AAA. Now there are two institutions that never got the punishment they deserved.

Anyway, thanks for your kind response. Some day we'll figure it all out. Probably around the time of the next crisis.

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I think I would blame people who, with fraudulent intent, went about circumventing the rules, and not the rules themselves.

For example, if I build a fence 8 feet high and someone jumps over it, I might blame myself for not making it 10 feet high instead of 8. But the fact of putting the 8-foot high fence is not the cause of them ending up on the other side of it.

So, if you can manage to sidestep the matter of fences and barriers with respect to negative allusions regarding regulatory dogmas of various types ... do you get the point?

Yes, whatever rule is made, someone will try to find their way around it. This does not mean that the best strategy is to throw your hands up in the air.

There would be no murders if their were no laws against murder. The laws making murder illegal drive people to commit murder by finding all the loopholes. Like claiming "self defense", "castle doctrine", "fear", ...

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"these regulations drove European banks and US shadow banks to become egregiously over leveraged and stoked insatiable demand for asset"

Stand your ground laws, allowing the defense of "fear for life" to justify murder, drives gun carriers to murder people, especially unarmed people and children and those running away???

You can't be arguing that eliminating all capital requirements including requirements the debt be secured by the property bought by the debt would drive demand for assets, tangible (real estate) and intangible (debt instrunents) to zero.

Or are you arguing that all assets having no legal basis for value would be properly valued at zero based on even irrational actors never paying a penny.

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